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Why is the Japanese bond market important?


The significance of the BoJ’s yield cap increase… what could this mean for global prices of risky assets? … the view of our technical experts on a “Santa Rally” … their short-term forecasts

One of the biggest headlines of the week came from a shocking decision by the Bank of Japan (BoJ).

As we covered here in the Digestthe BoJ made a big surprise on Tuesday by raising the cap on its 10-year bond yield from 0.25% to 0.50%.

It was essentially a de facto hike in interest rates, because that is tantamount to monetary tightening. Raising bond yields increases the cost of capital.

Now, what is shocking is that Japan was the last central bank in the world to resist tighter monetary policy. In fact, the BoJ has been in “accommodative” mode for – literally – decades. Specifically, since the 1990s following their historic stock market crash.

(In the 1980s, Japanese stock prices jumped 3 times faster than corporate earnings, causing the Nikkei to trade at a jaw-dropping price-to-earnings ratio of 60 in 1989. When the bubble burst, Japanese stocks fell 50% in a single year, ushering in the lost decade(s).)

So the idea that the BoJ would suddenly change policy this week came as a huge surprise to the financial world.

For more, let’s go to our technical experts, John Jagerson and Wade Hansen of Strategic trader. From their Wednesday update:

The BOJ has decided to start normalizing monetary policy, but we don’t know what “normal” monetary policy is for the BOJ.

Japan’s central bank has been the most aggressive in lowering rates and keeping them low among developed economies since the collapse of its own asset bubble in 1991.

To put that into perspective, the BOJ has only raised rates twice since 1990, in 2006 and 2007 just before the global financial crisis. Talk about bad timing.

…The BOJ’s “normal” monetary policy is to stimulate with low rates. So, this week’s move came as a huge surprise and caught economists and traders off guard.

From the perspective of an “American stock investor,” why should we care?

Because the Japanese yen has been a roundabout way for global investors to help support the US stock market.

Let’s go back to John and Wade to clarify this:

Over the past few years, investors around the world have borrowed yen at very low rates in order to buy higher-yielding assets like US stocks.

When the yen is cheaper, borrowing is even easier, and that benefits those other assets.

But now that Japan is showing the first signs of monetary policy tightening, this has an immediate impact on the yen. In the wake of the BoJ’s announcement, the yen jumped around 4% against the dollar this week. It’s a big move for just a few days.

Back to John and Wade:

A strong yen is bad for US stocks. The correlation between a stronger yen and falling stock prices isn’t perfect, so don’t panic about this week’s surprise just yet.

However, the two assets are getting close enough that this is a trend we should watch closely.

For example, the yen has been rising since the BoJ began supporting it on Oct. 21 and stocks have been unable to break trendline resistance over the same period – the S&P 500 has failed again after two attempts to break resistance over the past two weeks.

Let’s flesh this out to make sure we’re all on the same page.

If the BoJ continues these “hidden interest rate hikes” via its 10-year bond yield, it could have a significant impact not only on US stock prices, but also on bond prices, which could further worsen the impact on stock prices.

You see, Japanese investors haven’t received any meaningful income from their domestic 10-year bond for years. If that is changing and the Japanese bond market is poised to deliver a meaningful return, there is potential for a giant swell of capital from Japanese investors as they bring their money back to Japan. (they had to invest in foreign markets to find any meaningful returns for decades). But that would force Japanese investors to sell their current holdings of bonds from other countries.

And what do we know about the relationship between bond prices and yields?

When prices fall, as they would if tons of bonds suddenly flooded the market, yields would rise.

As we covered here in the Digestrising bond yields are a significant headwind for equities.

Now, it’s too early to say that this dynamic will play out. But as John and Wade suggested, it’s something we’ll want to watch closely in the coming months.

Meanwhile, make sure your kids don’t read this, but John and Wade say there’s no “Santa Gathering”

Let’s go straight to our resident Scrooges:

…Santa’s Rally isn’t a real thing; it’s just something that financial journalists talk about because it’s fun and attracts readers.

The Santa Claus rally is loosely defined as a probability that stock prices will rise the week before and/or the week after Christmas. However, a historical analysis of these weeks shows that the market is as likely to rise as any other two-week period during the year.

John and Wade think the more appropriate question is whether the S&P will find support at the end of the year.

From a technical standpoint, we lost support at 3,900 last week following the Fed’s rate decision. All eyes are now on level 3,800. We came across it yesterday. The question is whether we can get it back and retain support.

If not, how far do John and Wade see the S&P falling?

Back to their update:

In our view, the worst-case scenario is a return to previous lows near 3,600 on the S&P 500. Positive surprises from FedEx Corp. (FDX) and Nike Inc. (NKE) this week confirmed that consumer and business spending is still relatively strong.

While we don’t think the market will make new highs, these reports increase the odds that support will hold, and we won’t see price at or below 3,600 for some time.

Even though we are surprised and see higher than expected market volatility next week, take it with a grain of salt

Unless a headline rocks the financial world, any outsized market moves we’ll see in the coming days will be on light volume, which means we shouldn’t read too much into it.

The few days before Christmas and the week between Christmas and New Years usually mark the lowest market activity of the year. For this reason, the handful of buyers or sellers that show up can move prices much more than under regular volume market conditions.

Louis Navellier shared this with his subscribers in his issue yesterday Platinum Growth Club to update:

I know most people go away for the holidays so I wanted to drop you a quick note in case you were wondering why the market is down so badly [yesterday].

The fact is that there is no liquidity [yesterday]. Many traders have fled as the winter storm disrupts their travel plans. And [two days ago]although the market recovered, trading was still very illiquid.

… I wouldn’t worry about major market swings.

As we wrap up today, we’ll come back to John and Wade for the final word:

It may take some time before a new uptrend emerges, but a bounce up to trendline resistance in early January seems likely.

We’ll keep you posted here in the Digest.

Have a good evening,

Jeff Remsburg

InvestorPlace

Not all news on the site expresses the point of view of the site, but we transmit this news automatically and translate it through programmatic technology on the site and not from a human editor.
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