This morning, the Bank of Japan decided to reverse its strategy of injecting extraordinary amounts of money into its financial system. This means that the era of the Bank of Japan's so-called quantitative monetary accommodation is over, exactly five years after it began.

The BOJ's policy change validates the country's return to sustainable economic growth as well as its emergence from deflation, and will likely act as an accelerant to economic growth in Japan.

While the impact on world markets from the BOJ's shift is likely to be more a process than an event, the action already has had repercussions.

Japan Was in a Liquidity Trap

In announcing its policy change, the Bank of Japan said it would reduce "the outstanding balance of current accounts at the Bank of Japan toward a level in line with required reserves." The BOJ had kept its balances at 36 trillion yen since March 2001, substantially higher than the 6 trillion yen that it is required to keep by law.

In dollars, this means that Japan will reduce its excess balances from about $300 billion to about $50 billion. The money was previously needed because Japan was in the midst of a classic liquidity trap, wherein low interest rates failed to spark new lending.

In fact, lending had fallen on a year-over-year basis every year since 1996 until this February, when it increased 0.2% vs. a year earlier. With Japan's economy now on more solid footing, low interest rates should be enough to motivate continued growth in lending, which means Japan is out of its liquidity trap.

By changing policy, the Bank of Japan validates the recent good news in Japan and it will likely act as an accelerant growth. Potential borrowers might hasten their borrowing and consumers will no longer delay their purchases, seeing the BOJ's action as validation of Japan's emergence from deflation.

The bank had laid out three conditions it wanted to see in place before it could reverse its easy money policy.
    1) Core prices must exhibit a steady, rising trend for at least several months.
    2) Continued increases in prices must be reported (expected for February) to assure that deflationary readings won't return.
    3) Economy and markets must be able to withstand a reversal in policy.

The BOJ obviously feels that these three conditions have been met.

Implications for World Markets

Although there are indeed both short- and long-term implications to the Bank of Japan's policy change, it needn't send shudders throughout the world financial markets.

For one, it was largely expected, and Japan's return to sustainable growth is good news for the global economy.

Second, Japan's interest rates are likely to remain extraordinarily low for many more years. In fact, expectations are that Japan will raise rates by an average of about a half percentage point each of the next three years. Euroyen futures show that Japan's benchmark rate is expected to end 2006 at just 0.5%, and will be at just 1.12% at the end of 2007. The rate is expected to end 2008 at 1.55%.

Although expectations beyond the next two years are suspect, it is notable that Japan's short-term interest rate is expected to stay under 2% for the rest of the decade. That is low enough to encourage continued Japanese purchase of foreign assets, although the motivation won't be as strong as before.

Bearishness on the interest rate front has been apparent worldwide. Consider the recent rate move in the U.S., for example, which has put yields at multiyear highs. However, short-term bearishness is nearing an extreme judging by options activity on the 10-year T-note future. My records show that the 10-day put/call ratio is at a five-year high.

The bond market will have to get through Friday's payroll number and next Thursday's CPI, but conditions are ripening for a rebound, although the level the rebound occurs at will depend upon the data.

Impact on Treasuries

The U.S. Treasury market has worried about Japan's actions, as it probably should, given that Japan owns $685 billion of treasuries, $429 billion more than the second-largest holder, China.

The concern that Japan might buy fewer Treasuries is legitimate but probably excessive, in light of the fact that Japan hasn't added to its holdings since August 2004. Japan has actually been a net seller since that time, as it has been making efforts to diversify its assets.

The point is that even though the world's largest holder of Treasuries (actually the second next to the Fed, which holds $736 billion) stopped buying 18 months ago, long-term U.S. interest rates stayed very low both on an absolute basis and on a relative basis, with the yield curve having inverted during the period.

With Japan likely to continue to earn dollar reserves and with its period of diversification already progressed, Japan is not likely to be a major seller of Treasuries for some time.

Impact on Commodities

The collective impact of monetary tightening in Japan, Europe and the U.S. is a bearish factor for the commodity market. One key impact to watch is how the tightening weighs on commodity prices and whether it forces an unwinding of commodity-related trading strategies. While lower commodity prices are welcome from an economic perspective, there are sizable financial positions held in stocks, bonds, commodities and currencies all geared toward rising commodities prices.

Investors are leaning heavily on one side of this trade. They are long the commodity-based equities, long commodity-based currencies, long the fixed-income instruments of countries benefiting from higher commodity prices and long the commodities outright.

It has been an easy trade, up until now, and we all know how these easy-money trades end.

The global monetary tightening is sowing the seeds to an end to this easy trade. That said, there are of course many supply/demand fundamentals that will support the commodities against any lasting weakening. Still, as I've said in my RealMoney blog, the unwinding of commodity-related trades could be large enough to be the next big trade in the financial markets.

Again, keep in mind that it will be many years before Japan's policies can be considered tight, so the impact on world markets will be more a process than an event. That said, the transition to this new policy is already with repercussions, so each rate move has relevance, as has been seen so far in 2006.
Tony Crescenzi is the chief bond market strategist at Miller Tabak + Co., LLC, and advises many of the nation's top institutional investors on issues related to the bond market, the economy and other macro-related issues. At the request of the Federal Reserve, Crescenzi is a regular participant in the board's Livingston Survey of economic forecasters. He is also the author of The Strategic Bond Investor. At the time of publication, Crescenzi or Miller Tabak had no positions in the securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Crescenzi also is the founder of Bondtalk.com, a popular Web site covering the bond market and the economy. Crescenzi appreciates your feedback; click here to send him an email.

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