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.
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.
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.
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.
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.
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.