It's officially over. After 15 years -- yes, 15 years -- of no growth, Japan's economy is poised to grow by as much as 5% in 2006. After eight years of slowly but steadily falling prices, Japan can now smell a welcome whiff of inflation. And after years and years of 0% short-term interest rates, the Bank of Japan is widely expected to finish the year raising those same rates to 0.5%.

So take a moment to cheer for the end of what has been called the lost decade in Japan. Then buckle your seat belts.

Because what's good for the Japanese investor and the Japanese CEO and the Japanese consumer isn't at all good for international financial markets. The recovery in Japan is likely to usher in hard times in financial markets and economies around the globe. And no economy is at greater risk of taking a body blow from a Japanese economic recovery than that of the U.S.

The problem is that during Japan's lost decade the world has gotten hooked on ridiculously cheap Japanese cash sloshing around the financial markets.

The Downward Spiral

The Bank of Japan pursued two strategies as it fought to bring the country out of the deflationary slump that gripped the nation after its stock market started collapsing in the 1990s.

  • The bank cut short-term interest rates to 0%. This move received the most attention around the world. The problem that the Bank of Japan ran into is one that keeps central bankers around the world up late at night worrying: Once deflation has really taken hold of an economy, cutting interest rates won't help. With prices falling steadily and consumers convinced that they'll keep falling, there's no incentive to borrow today to buy today; prices will be lower tomorrow.

    With consumer demand slumping, businesses have no incentive to borrow, even if the money is effectively free, since they are looking at falling, and not growing, customer demand in the future. The lack of consumer and business spending increases the level of worry about the future. That, in turn, encourages consumers and businesses to hold on to their cash rather than spend it.

  • Faced with these deflationary expectations and having exhausted the conventional remedy of lower interest rates, the Bank of Japan launched Japan onto uncharted financial seas. If cutting interest rates to 0% didn't jump-start Japan's economy, maybe flooding the economy with money would work. At the worst, it would at least prevent the collapse of banks and industrial companies struggling under the burden of loans made during the height of Japan's great real estate bubble, which had since turned sour.

    Opening the Floodgates

    This effort took many forms. In September 2002, for example, with the Nikkei 225 stock index at 9000 -- down more than 75% from its high of nearly 38,916 at the end of 1989 -- the Bank of Japan started to buy shares in troubled companies to keep the Japanese stock market from sliding even lower. To keep the market for Japanese Treasury bonds functioning smoothly, the bank also bought government bonds. And in an effort to flood the financial markets with free money in the hope that somebody would borrow it if it was just cheap and plentiful enough, the Bank of Japan bought billions in short-term debt.

    Calculations by The Financial Times put the extra cash at something like six times beyond what the bank needed to put into the Japanese financial markets to get interest rates to fall to 0%. The bank's target for liquidity soared from something like $50 billion when this policy began some five years ago to something like $250 billion to $300 billion by the time the bank decided last week to end its policy of flooding the markets with cash.

    Until this year, pretty much nothing happened. Japanese consumers and businesses that weren't interested in borrowing $1 of free money were just as uninterested in borrowing $2 in free money, it turned out. It took a quite probably unrelated boom in exports to China and the U.S. to start getting the Japanese economy rolling again last year.

    So if no one in Japan wanted to borrow all that free money the Bank of Japan was pumping into the economy, what happened to it?

    It went overseas -- looking for higher returns.

    Some was invested by Japanese savers, banks and investment companies. A favorite investment was the relatively high-yielding debt issued by the U.S. Treasury. Japanese holdings of U.S. Treasury debt climbed 115% from "just" $318 billion in December 2001 to $685 billion in December 2005. China has shown faster growth in recent years -- to $257 billion in 2005 from $79 billion in 2001. That's 225% in four years. Still, Japan remains far and away the biggest holder of U.S. Treasuries.

    Some of the cash was borrowed in Japan by overseas investors who used the free money to buy U.S. Treasuries, gold and mortgage-backed securities, among other assets. This carry trade, as it's called, is extremely profitable, because access to free money means that investors can leverage their own cash with borrowed money to the tune of 5 or 10 or 20 to 1.

    Gates Closing -- Gently, One Hopes

    On March 9, the Bank of Japan announced that it will gradually reduce the amount of free cash floating around Japan -- and, as a consequence, floating around in global financial markets.

    Being a responsible central bank, the Bank of Japan will try to do this gradually, so it doesn't crash financial markets. While the bank will reduce its buying of Japanese government bonds, it will continue to buy about $10 billion of government bonds each month. The worry is that if the Bank of Japan went cold turkey, it would crash the market for Japanese government debt. It's not like investors are beating down the door to buy debt paying 1.6% (on 10-year notes) issued by a government whose total debt is now more than 150% of the country's gross domestic product. (By contrast, the Office of Management and Budget estimated total U.S. debt at the end of the 2005 fiscal year at 63.7% of gross domestic product.)

    Global financial markets are thus looking at two big changes.

  • The Bank of Japan is very likely to join the U.S. Federal Reserve and the European Central Bank in raising interest rates as 2006 goes along. A hike from 0% to 0.5% isn't enough to make investors salivate at the thought of owning Japanese debt, but it is clear what the trend is. The huge yield advantage enjoyed by U.S. Treasuries over yen- and euro-denominated debt is starting to shrink.

  • Even if borrowing in Japan remains really cheap, the amount of money available to borrow in Japan will fall as the Bank of Japan reduces liquidity. A shrinking Japanese money supply itself will eventually drive up interest rates. But just as important, reducing liquidity increases worry among traders about their ability to get in and out of positions quickly.

    All this set the global financial markets in motion even before the Bank of Japan announced its formal policy change. For example, gold, one of the assets with which investors have used the yen-carry trade to generate big leveraged profits, fell 4.9%, or $26.70, for the week, to $541.30.

    Losing Our Biggest Lender

    Meanwhile, yields on 10-year U.S. Treasury notes have been on the rise -- and that means prices have been falling. On March 7, the intraday yield on the 10-year note climbed to 4.781%, the highest level since June 2004. That climb in yield pretty much eliminated the inverted yield curve that had so worried investors -- and economists -- at the end of 2005 and the beginning of 2006.

    An inverted yield curve, a condition that results when the yield on short-term notes such as the two-year Treasury is higher than the yield on 10-year notes, is often seen as a harbinger of recession. Investors who would normally demand a higher yield to tie up their money for a longer period of time would be willing to take less in yield if they thought the economy was about to tip into recession. The economic slowdown that a recession brings usually results in falling interest rates, so investors in 10-year bonds would be taking a lower yield now in hopes of getting a good capital gain on their bonds if a recession brought interest rates down.

    But the end of an inverted yield curve isn't likely to provide much beyond a passing comfort to bond investors. Anything that reduces the propensity of Japanese -- and other foreign -- investors to buy U.S. Treasury bonds is a big deal in a country that will set another record for highest trade deficit in 2006. Expectations are that 2006 will break 2005's record deficit of $723 billion.

    When you owe this much money and you are so dependent on overseas investors to buy your debt, an announcement that your biggest creditor will start sopping up liquidity isn't exactly good news.

    The global debt markets are so leveraged and so dominated by complicated derivative bets that it's impossible to tell what would tank the market.

    My gut feeling -- and that's all it really can be, given the complexity of the markets -- is that we're not yet at the crisis point. But the Bank of Japan's good news will put more upward pressure on global and U.S. interest rates.

    No debtor -- whether it's the homeowner with an adjustable-rate mortgage or the U.S. government -- can be happy about that.

    New Developments on Past Columns

    Why Gold Stocks Will Rise : The Bank of Japan's March 9 decision to gradually suck the excess cash out of the financial market that it had poured in to fight deflation has sent the price of gold and other commodities down. Speculators have used money borrowed at near 0% interest in the Japanese market to make bets on everything from gold to silver to copper. And although the Bank of Japan doesn't look likely to raise interest rates until later in 2006 -- and then only to 0.5% -- some speculators have started pulling their money back so they won't be the last one out the door.

    That's the bad news for the prices of these commodities and of the stocks of commodity producers. The good news is that, after a relatively modest drop as speculative money pulled out, actual consumers of these commodities have stepped in to buy. For example, gold, at a two-month low near $530 an ounce, has attracted buying from jewelry makers who have been looking for exactly this kind of a price dip to rebuild their inventories. Copper and aluminum saw similar bounces on buying from industrial consumers on March 10.

    Right now, it looks like this physical demand will be enough to stabilize prices, though the situation demands close attention. A rally from current levels will depend on the strength of the global economy.
    Jim Jubak is senior markets editor for MSN Money. He is a former senior financial editor at Worth magazine and editor of Venture magazine. Jubak was a Bagehot Business Journalism Fellow at Columbia University and has written two books: "The Worth Guide to Electronic Investing" and "In the Image of the Brain: Breaking the Barrier Between the Human Mind and Intelligent Machines." As an investor, he says he believes the conventional wisdom is always wrong -- but that he will nonetheless go with the herd if he believes there's a profit to be made. He lives in New York. While Jubak cannot provide personalized investment advice or recommendations, he appreciates your feedback; click here to send him an email.

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