Publish date:

Land of Rising Rates

The Bank of Japan gets set to remove its 'super' easy policy as the economy follows the Nikkei higher.
Author:

Amid solid signs that Japan's economy is picking up and the decade-long deflationary spiral has finally ended, the Bank of Japan is set to gradually end a policy that has kept Japanese interest rates near 0% for more than four years.

Higher rates don't always mean good things for equities. But in Japan's case, they signal that the economy and profits are likely to improve. Some analysts expect that Japan's Nikkei stock index, which has already gained 16% over the past month and a half, is poised for more stellar growth.

Back in March 2001, the Bank of Japan (BOJ) used emergency means to counter a drying-up of liquidity in Japan's financial system, which manifested itself via sustained drops in prices and a sharp slowdown in the economy.

The central bank adopted a "quantitative easing" policy whereby the central bank pumped money into the financial system by maintaining the aggregate current-account balances of private-sector banks at 30 to 35 trillion yen ($265 to $309 billion).

TST Recommends

The BOJ vowed to maintain its policy stimulus until core consumer prices stabilized at zero or above. That time seems to be at hand, according to numerous statements from BOJ officials over the past few weeks.

On Thursday, BOJ governor Toshihiko Fukui said that while the central bank would continue to monitor "economic and price conditions" closely, the BOJ may gradually start undoing the policy as early as next spring.

"On the basis of the outlook of the economy ... it is increasingly possible," Fukui said, according to

The Associated Press

.

After the overnight comments, the yield of Japan's 10-year government bond rose 0.07 percentage points to 1.47%, while the yield of the five-year bond surged to a 13-month high of 0.805%.

The Nikkei, meanwhile, rose 1.3% to 13,617. Merrill Lynch chief economist Dave Rosenberg notes that the Nikkei has gained 19% so far this year, making Japan's equity market one of the world's top performers, on par with Canada's, and above European markets.

The U.S. equity market, Rosenberg notes, is the only major market not up for the year. As of Wednesday's close, the

S&P 500

was up 0.4% in 2005 -- thanks largely to surging energy stocks -- but the

Dow Jones Industrial Average

was down 2.9% year to date while the

Nasdaq Composite

was down 2.8%. (In midday trading Thursday, stocks were up slightly as energy prices bounced around; blue-chip averages were lifted by the likes of

AIG

(AIG) - Get Report

and

Disney

(DIS) - Get Report

.)

But there's more to come for Japanese equities. According to IdeaGlobal strategist Divyang Shah, the Nikkei is now poised to rise all the way to 18,000-19,000 over the next 18 to 24 months.

"The BOJ is tightening because inflation is moving up, which means that firms will now finally have room to boost prices and increase their profit," he says.

Furthermore, the BOJ's moves will not really mean a tightening of monetary policy until they have reduced the quantitative easing policy targets to 5 to 10 trillion yen on private sector banks' current account balances.

The BOJ will remain very cautious about weaning banks off its easy-money policy and will want to make sure that no excess risk has been taken by Japanese institutions (often a symptom after long periods of easy money) and that these banks are able to start lending to each other more frequently.

"It's going to be a long drawn-out process," which should last about eight to 13 months, Shah says.

In the interim, "the net result could be a bond market that stays largely stable and ideal conditions for the equity markets to flourish," he added.

Overnight, the yen also gained against the dollar. The prospects of a tighter monetary policy and the outlook for Japanese equities should fuel more yen buying. But this could prove problematic for the BOJ, says Shah. The bank has maintained an interventionist stance to keep its currency low enough to fuel exports. The BOJ may begin to relax this approach, however, especially if China makes further moves to revalue the yuan.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

click here

to send him an email.