How Japan sank the U.S. market

Now that the Japan's economy is growing again, the Japanese central bank has been pulling cash out of its money markets to keep inflation in check. Here's how that fed a global market pullback. By Jim Jubak

Trying to make sense of the global stock market sell-off that began on May 13? Remember that old Wall Street saying, "Don't fight the Bank of Japan." If you want to know what has rattled stock markets around the world and when you can expect it to end, study the Bank of Japan. What's that? You thought the saying went "Don't fight the Fed"? How yesterday. Right now the Bank of Japan, not the U.S. Federal Reserve, is the most important central bank in the world. It's the Bank of Japan that's calling the tune for the world's equity markets.

Slip sliding away
For the last week, you've heard all the talking heads focus on the U.S. Federal Reserve in their efforts to explain the sell-off that began on May 13. The market decline, which reached a temporary crescendo with May 17's 214-point tumble on the Dow Jones Industrial Average ($INDU), is a result of worries that U.S. inflation is in danger of spinning out of control and that the Federal Reserve will have to raise interest rates at its June meeting and beyond.
Core inflation -- that is inflation without volatile food and energy prices -- hit an annual 2.3% in the April Consumer Price Index numbers reported on May 17. That's perilously close to the 2.5% inflation rate that many think is the top of the range that the Federal Reserve will tolerate. After those numbers came out, the odds of a June 29 interest-rate hike, as indicated by prices in the Fed funds futures market, climbed to 50% from 35%.

That's not a huge shift -- to 50/50 from a 35% chance. And you'd think while the stock market wouldn't welcome another interest rate increase -- higher interest rates, which increase the attraction of alternative investments such as bonds, are never great for stocks -- it would have gotten used to them by now. A rate increase in June would be the 17th quarter-point hike since the Federal Reserve began raising short-term interest rates in June 2004. The stock market has proven itself perfectly capable of rallying while the Federal Reserve raises interest rates. Before this recent sell-off, the Dow was up 12% since the Fed began raising interest rates from 1% on June 30, 2004.
It certainly wasn't enough to send the U.S. bond market into a swoon. Bonds actually rallied on some days when stocks were sinking. On May 18, for example, when the Dow Jones industrials fell 77 points and the Nasdaq Composite ($COMPX) fell to its lowest level since November 2005, the 10-year Treasury note actually climbed in price by 0.75%. The yield on the 10-year note, which moves in the opposite direction to prices, at 5.07% on May 18 was very little changed from where it stood at 5.12% on May 10, the day the Fed announced its latest hike in interest rates.

Gold also behaved oddly. The metal is the classic inflation hedge, and yet gold sold off on these inflation worries -- if that's what they were. The metal, which had been selling at $700 an ounce on May 10, closed at $657.50 an ounce on May 19. That's a drop of 6% when gold should have been climbing -- if the financial markets were focused on the U.S. Federal Reserve and heightened fears of inflation.

And finally there was the strange behavior of the U.S. dollar. If worries centered on the U.S. Federal Reserve and concern that the Fed and its new Chairman Ben Bernanke had lost control of U.S. inflation, you'd expect the dollar to sink against other global trading currencies as investors sold dollars to find safer havens in euros and yen. But instead, the U.S. dollar has actually stayed steady against these currencies. The U.S. dollar sold for 110.6 yen on May 10 and for 110.7 yen on May 18.
Not the Fed but the bank
This is where the Bank of Japan comes in. You can't understand why some asset prices have tumbled and others have stayed rock solid if you don't know what the Bank of Japan has been doing over the last few months.
As good as its word, the Bank of Japan has been taking huge amounts of liquidity out of the global capital markets. In an effort to re-inflate the Japanese economy and end the years of deflation that had kept the country mired in a no-growth swamp, the Bank of Japan had pumped billions into the country's banking system. Now that the economy is finally growing again and now that prices aren't sinking any longer, the Bank of Japan has given two cheers to the return of inflation and has started to remove some of that cash from the financial markets.

In the last two months, the bank has taken almost 16 trillion yen, or about $140 billion, in cash deposits out of the country's banks. The country's money supply has fallen by almost 10%. The Bank of Japan isn't finished pumping out the liquidity that it had pumped in. That should take a few more months. And when it is finished, the Bank of Japan is expected to start raising short-term interest rates.

No more cheap
This sign of the return of economic and financial health to Japan is, however, bad news to the speculators who have used cheap Japanese cash to make big profits by buying everything from Icelandic bonds to Indian stocks. The momentum in many of the world's riskier markets was a result of ever increasing floods of cash -- borrowed at 1% in Japan and multiplied by leverage as speculators turned $1 of capital into $3 or more of borrowed money.

For example, India's Mumbai stock market, up 21% in 2006 and 70% over the last 12 months, has seen an inflow of $10 billion in overseas money. That wouldn't be enough to move a market like the $14 trillion (market cap) New York Stock Exchange, but it's a bigger deal on the $742 billion Mumbai market. Although $10 billion isn't enough to move a market by itself -- that took improving fundamentals in the Indian economy -- it is enough to increase upside momentum once the ball is rolling. (The Indian market's benchmark BSE index plunged 10% Monday before trading was halted for an hour. It ended the day down 4.2%.)

New inflows of cash are needed to keep the momentum going, hot money investors know, and it looks like the supply of money flowing into these markets might diminish. The moves to date by the Bank of Japan aren't enough to radically diminish global liquidity, but they are enough so that the investors who have fed some of the world's riskier markets understand that the trend has turned.

It's one thing to invest in five-year Indonesia government bonds paying 12.13% when cash is flowing into the Jakarta financial markets, keeping the rupiah strong against the dollar and pushing Indonesian stocks ever higher. It's something else entirely when it looks like investment flows might be drying up. Speculators aren't about to wait until they actually see signs that cash flows are dwindling. They take profits at the first sign that the trend may be changing. That's why the Jakarta market can drop 5.3% in a day, as it did on May 18.

What we've witnessed since May 13 is a global flight out of more leveraged and more speculative investments. Speculators attracted by the momentum of the gold, copper, and silver markets have sold -- and are still selling -- rushing to get out before other speculators could liquidate their positions. Emerging equity markets have sold off for the same reason: India's Bombay Sensex index dropped 6.8% on the same day as the Jakarta market fell. High-yielding bond markets have collapsed as prices dropped, sending yields soaring and currencies skidding. The central bank of Iceland has raised interest rates to 12.25% in an effort to prevent the further fall of the krona as hot money flees the country.

Risky investments look riskier
What the Bank of Japan has done is to set off a global re-setting of investors' risk tolerance. With Japanese interest rates so low and Japanese cash so abundant, speculators, traders, and investors have been more and more willing in the last few years to take on risk at increasingly low premiums.

It isn't amazing that anyone would buy Indonesian bonds. It's amazing that they would buy them when the yield was only 12%. And given what we know about the direction of U.S. interest rates, the likely course of U.S. inflation and the size of the U.S. trade deficit, it was amazing that so many investors flocked to buy 10-year U.S. Treasury notes that they drove the yield in July 2005 to less 4%. On July 10, the 10-year Treasury yielded 3.97%. By locking up your money for eight fewer years in a 2-year note, you could get 3.62%. That's 0.35 percentage points in yield for taking on eight more years of risk.

Risk tolerance doesn't get reset in a day. The Bank of Japan is only halfway through removing liquidity from its domestic and global markets. Interest-rate hikes are likely to follow that with the first increases coming in the second half of 2006. At the same time, the European Central Bank is raising interest rates.

All excess liquidity has by no means been removed from the global financial markets. But the speculators know that money is gradually getting more expensive. Rallies can count on less hot money to fuel their last stages. Getting out earlier in rallies starts to seem wiser. Some risks are just not worth taking.

The correction that began on May 13 is part of the process of resetting risk tolerance and recalibrating risk premiums. It's not likely to last terribly long. Frankly I think the turn in this correction isn't that far off, and it's probably time to look for a buy or two. And it's likely to be followed at some distance by another bout of speculative momentum, which will be followed by another correction. Markets move from one equilibrium point to another by a messy process of over-shooting on each extreme of the swing until they find a new center.

That's where I think we are now, and that's what you can expect to see for the rest of 2006 as the Bank of Japan continues to force a recalibration of the risk tolerance of global investors. The volatility that results can be scary, but it doesn't mark the end of the world. It's rather just the way that, in the short term, the financial markets adjust to new fundamental conditions, such as a change in global liquidity.

It looks like those new funds that track commodities prices and have helped push the prices of gold, copper, platinum, and silver to historic highs have also been a major contributor in the recent sell-off. At least, that's the conclusion I draw from noting that all the commodities are falling in lockstep -- a sign of index selling. There's about $90 billion invested in funds that track commodities indexes -- about a sixfold increase in the last four years, according to The Financial Times. A lot of this is hot money that follows the momentum, and those investors are likely to be selling their positions in commodity index funds now that the momentum has broken. That selling, of course, results in redemptions of index-fund shares, and that in turn forces the index fund to liquidate positions, forcing commodities prices yet lower and leading to another round of selling.

Another key reason for commodity index-fund selling is a technical change in the commodities options market. Because many commodity options 12 months out now cost more than three-month options -- the options version of the inverted yield curve, since normally future options cost less than current options -- it currently costs an index fund money to roll over its options every three months. When the options curve is "normal," index funds are able to make money on rolling over their options. This "roll yield" has been a key factor in the outperformance of commodity index funds, and its disappearance -- caused, ironically by the popularity of commodities -- makes these index funds less attractive investments. And that re-enforces the selling pressure.

Jim Jubak E-mail at jjmail@microsoft.com . At the time of publication, Jim Jubak did not own or control shares of any of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column.