Global Briefing: In Japan, Trying to Limit Long-Term Bond Yields

But governments generally have little control over these matters.
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Following Wall Street's slide yesterday, stocks are lower,

lending support to the debt markets. The dollar is faring better than expected in the face of the decline in equity prices. In the past some commentators have linked either a fall or increased volatility in U.S. stocks to weakness in the dollar. The greenback rose to its best levels in a couple of weeks against the yen and is steady near its recent highs against the euro.

Japanese government bonds reversed early weakness to eke out a modest gain late in the session amid talk that U.S. pressure may tilt the balance in favor of the

BOJ

buying more bonds. This left the yield on the benchmark bond some 44 basis points below last week's peak. Senior Japanese officials also suggested that the U.S. should consider buying JGBs, as Japan has done for the U.S. over the years to help finance its budget deficits.

It is highly unlikely that this proposal will get implemented, but it does show Japan is groping for a way to limit the rise in long-term yields.

Even if the BOJ increases its rinban (bond purchases from the market), as I expect, it will not necessarily cap bond yields. Governments have very limited control over long-term interest rates. Even President

Kennedy's

so-called "Operation Twist," which Japanese officials are reportedly considering duplicating, did not succeed in bringing down long-term interest rates.

There were also rumors in the foreign exchange market that Finance Minister

Miyazwa

intimated that the dollar would not be allowed to fall below 110 against the yen. The BOJ intervened to buy dollars in the middle of January when the dollar fell convincingly through that area. With Japanese markets closed for a holiday tomorrow, the immediate focus is on Friday's BOJ meeting. Many market participants are expecting Japan to lower its already historically low short-term interest rates. Given the current environment, the failure to do so could see a renewed decline in JGBs. Until Japanese markets reopen, the dollar is unlikely to rise much above the 116 area.

European bonds are higher in the wake of the slide of the major bourses, while the foreign exchange market is becalmed. There have been a few developments of note. First, Germany reported a much larger-than-expected decline in its December 1998 trade surplus. The December surplus of 5.6 billion marks is the smallest monthly surplus in two years and compares to the November surplus of 15.3 billion marks. The slump in exports is the main culprit.

The smaller trade surplus helped swing the 2.2 billion-mark November current-account surplus into a 1 billion-mark deficit in December. The consensus called for around a 5 billion-mark current-account surplus.

However, it is the implicit threat of a strike among metal workers that is the chief focus.

Talks between employers and workers were called off yesterday. The union is expected to vote as early as tomorrow to strike. After years of pay restraint, the

IG Metall

union, representing some 3.4 million workers, is seeking a 6.5% pay increase. The employers are offering less than half of that. Although

European Central Bank

President

Duisenberg

has intimated a significant fall in price pressures will be needed if there is to be another easing, a damaging strike in Germany, the largest economy in the eurozone, could further undermine growth prospects. Strong growth in Europe is required for continued fiscal reform. For example, Italy's disappointing 1.7% growth last year, the lowest in the eurozone, is hampering efforts to reduce its deficit and debt levels, something that the

European Commission

warned Italy of earlier this week.

The

Bank of England's

quarterly inflation report keeps the door open on additional interest rate cuts in the coming months. It indicated that price pressures were easing and that growth prospects were worsening. It warned that growth in the first half of this year could be close to nil. It assessed about a 20% chance of a recession. It also noted that growth in the eurozone, among its chief trading partners, was weaker than anticipated and that the Japanese recession could last longer.

The report buoyed the British debt instruments and reversed the early decline in the short-sterling futures contracts.

The British pound itself showed little reaction to the report. Rate cut fever is also running high in Sweden. A 20-basis-point cut in the repo rate on Friday is widely expected that would bring the key money market rate down to 3.20%. The

Riksbank

targets 2% inflation. In December, the measure of inflation that excludes mortgage interest rates, indirect taxes and subsidies stood 60 basis points above 1997 levels. The Swedish krona has appreciated about 6% against the euro over the past six weeks, which by itself is tantamount to some tightening pressure.

Although yesterday's auction in Brazil was well received, it is premature to say that the corner was turned. The one-year bonds that were sold at an average yield of 38.82% (vs. 40.41% last week) may not be truly representative of the willingness to invest in Brazil. The bonds had a unique feature of offering a fixed rate for the first seven days and then a floating rate tied to market rates. This means that they were not as risky as it may have appeared.

There are still ongoing concerns that Brazil may be forced to restructure its domestic debt.

In contrast, Mexico's auction saw short-term rates fall to their lowest level since last August. The yield on the benchmark 28-day cetes fell 53 basis points to 30.39%. Further declines are likely in the weeks ahead, provided the peso remains steady. January inflation was reported a touch lower than expected at 2.53%.

Marc Chandler is an independent global markets strategist. At the time of publication, he held no positions in the currencies or instruments discussed in this column, though positions may change at any time. While he cannot provide investment advice or recommendations, he invites you to comment on his column by sending a letter to mchandler@erols.com.