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The Next Big Step: Monetary Tightening

By Darrel Whitten


A 180 ON INFLATIONARY EXPECTATIONS...

TOKYO (KWR) -- The sharp but brief 825-point sell-off in the Japanese market in late October had within it hints of what investors can expect when the Bank of Japan (BOJ) is eventually forced to abandon its zero interest rate policy (ZIRP), or even when the U.S. Federal Reserve (FED) moves first.
By sector, the biggest losers were the financials, including the banks, securities companies, other financials and insurance. There has been some serious foreign institutional money coming into the banks during this rally, in addition to short covering by the hedge funds.

As long as foreign investors keep buying, the market technicals of the financials should provide support. Conversely, any correction that causes a serious breakdown in the market technicals of the financials is a warning sign of a significant shift in sentiment. That would bring about an extended correction, one that could be instigated by perceived changes in monetary policy-ostensibly first by the US FED, and then by the BOJ.

Actually, such a move by the central banks would be good news for the US and Japanese economies, as it would signal that central banks were confident enough in the sustainability of the economic recovery to begin pulling some liquidity off the table. However, if the moves are more aimed at pre-empting inflation -- i.e., primarily because of commodity price movements and the weak dollar -- market liquidity could dry up before earnings are strong enough to drive the market rallies.

...HAS THE CENTRAL BANKS TRYING TO KEEP IT SUBDUED

The sudden improvement in the U.S. employment picture has some economists scrambling to revise their views on when the Federal Reserve will raise interest rates, but the FED for its part is trying to play down these fears. According to Alan Greenspan, "in these circumstances, monetary policy is able to be more patient." Fed Governor Ben Bernanke acknowledged some improvement in the labor market, but emphasized there was considerable scope for policy to remain accommodative. However, financial futures markets, regardless of what the FED was saying, had the fed funds contract showing a 90 percent chance of a 25 basis point rise after the strong jobs report, up from 70 percent before the statistics were released. Presently a rate rise appears fully priced in for May of next year.

Japan's economic growth probably slowed to an annualized rate of 1.5 percent in the third quarter, but there has been a substantial improvement in business sentiment. A stronger stock market, evidence of economic recovery and reduced financial sector and corporate bankruptcy risk have all contributed to the improvement in sentiment. This has the Japanese press and investors already speculating about when and how the BOJ would abandon its ZIRP.

The BOJ has responded by releasing its medium-term outlook for inflation, which saw Japanese consumer prices remaining minus through FY2004, implying no change in the BOJ's quantitative easing until March, 2005. This notwithstanding, the debate about how and when to "normalize" monetary policy is already underway within the Bank, while it is taboo to mention this debate in pubic circles.

The BOJ itself and Japan's economy as a whole can ill-afford to have market expectations about inflation get out of hand. As the BOJ itself holds JGBs worth JPY64 trillion versus capital of JPY5 trillion, the Bank would have negative net worth should a renewed surge in bond yields wipe out 10% of the value of their JGB holdings. As they continue buying JPY1.2 trillion of JGBs every month, this exposure continues to grow. Thus in the words of BOJ governor Fukui; "It is necessary for the BOJ to keep the current easy policy in order to ensure an economic recovery and to develop (read protect) the role of the financial system."

FOREIGN INVESTOR PERCEPTIONS WILL LEAD

Foreign investors remain the main driving force of the Tokyo market, although their buying has slackened noticeably in October, and there is some evidence of profit taking. On the other hand, there is no sign that the net selling by domestic institutions is abating. While individual investors have been very active traders (accounting for more of the value of shares traded than foreign investors), they are not exactly buying and holding. Moreover, their sentiment has been positively stimulated by active foreign buying.

But a major change of direction (i.e., from providing as much liquidity and monetary stimulus as possible to an increasingly tight monetary policy) has historically led to an interim correction in stock prices, as investors adjust to stock prices driven by excess liquidity to stock prices driven by earnings fundamentals and valuations. This is why stock prices tend to perform best in the early stages of an economic recovery, while monetary policy is still focused on trying to stimulate the economy, rather than trying to inhibit growing inflationary pressures.

If foreign investors perceived that a move to tighten monetary policy by the FED was imminent, it may have the same effect as move by the BOJ, as the expectation would be that the US move would eventually be followed by a move by the BOJ, assuming of course that the Japanese economy is indeed now in a sustainable recovery phase. A perceived change in monetary policy would prompt portfolio re-positioning to cope with the impact this would have on asset allocations and sector selection.

Already, the larger capital, international blue chips as reflected in the Topix Core 30 recently corrected more even though the index has lagged its smaller capital peers during the rally. These stocks of course are more sensitive to foreign investor perceptions. Conversely, the small-cap JASDAQ has out performed the Topix by nearly two-fold, and could withstand a shift in monetary policy that did not seriously inhibit the economic recovery.