Historic Move by Bank of Japan Creates Selling Opportunity

TheStreet.com

NEW YORK (BinaryOptions.com) -- The Bank of Japan's latest monetary experiment is one of the most daring in recent times, essentially doubling the country's monetary base by the end of 2014.

In the first policy meeting headed by Haruhiko Kuroda, the central bank discussed plans to buy $520 billion (50 trillion yen) in government bonds each year. This figure comes to nearly 10% of annual gross GDP in Japan and will include both long-term government bonds (with maturities as long as 40 years) and assets from riskier categories (such as ETFs and REITs).

The aggressive program was announced in an attempt to reverse systemic deflationary pressures and revive growth prospects in a long-stagnant economy.


Markets were expecting additional stimulus announcements at the April meeting but the majority of analysts had a much more limited outlook. To put the Japanese central bank's plans into perspective, we can compare this version of quantitative easing to what has already been implemented by the Federal Reserve.

The Fed's plan commits to $85 billion in monthly bond purchases and agency-backed mortgage securities. This comes to roughly 6.8% of the $15.1 trillion gross GDP seen annually in the US, roughly 2/3 of the proposals in Japan.

Defining the BoJ's Goals

The broad scope of these programs has led some analysts to suggest that these moves amount to outright central-bank funding of the government. But the main reason behind these massive monetary injections is to encourage consumers and businesses to borrow more and to take advantage of lower long-term interest rates.


In theory, this could stimulate business activity as corporations use the extra cash as funding for expansion. At the same time, the hope is that consumers will take the opportunity to buy real estate with the cheaper available cash. With more money injected into the system, the best case scenario would show people spending the extra funds (at cheaper rates), driving consumer demand, and putting upward pressure on consumer prices. The BoJ's commitment now is to achieve a yearly inflation rates of 2%.

What are the Risks?

Some analysts are skeptical, however, saying that the sluggish Japanese economy and weakness in export markets will prevent businesses and consumers from taking the added initiative to borrow more money. If this is the case, all of the extra cash will not flow out of the banks and into the real economy. In the worse case scenario, cheaper borrowing rates will incentivize the much-discussed "carry trade," as investors fund purchases in higher yielding assets using low yielders like the Japanese currency. Sending funds out of the country in this manner would greatly diminish the intended effects and do little to positively influence real economic growth.

This scenario does create the added positive of weakening the yen. A weaker currency creates benefits for Japanese export companies that are able to offer products at cheaper prices to overseas customers. These companies can then build on those profits once the foreign earnings are deposited back into domestic banks.

But even with these minor positives, we could see a long-term situation where policymakers become overly dependent on stimulus measures, and face an expanding money supply that is unmatched by real economic growth. Additionally, a surge in bond sales will lead to a massive increase in Japanese government debt, which is already the highest in the industrialized world (230% of GDP). Most economists agree that debt levels in this range are unsustainable.

If the BoJ's proposals are successful (and inflation does start to rise), interest rates in Japan will need to rise as well. A situation like this will create substantial increases in interest payments for the Japanese government (magnified by the size of the outstanding debt).

If the government does not have the cash to make those payments, more bonds will likely be sold to raise the necessary funds. If this sounds like a vicious circle, it should. At its April meeting, the BoJ did little to address these potential concerns, but it would be naive to assume that this means those concerns are not being felt.

What Does This Mean for Investors?

Now that the BoJ has laid a clear framework for its aims going forward, investment ideas should be based on the assumption that the Japanese yen is in the early stages of a long-term downtrend. If you are Japanese, this means you should spend all of your domestic currency. Or, at least, take your money out of Japanese banks and put it somewhere where you will not suffer a massive depreciation in purchasing power. If you are a non-Japanese investor, this means it is time to borrow in yen and use those funds to buy more productive assets in countries that are not as fiscally-stretched.

After the BoJ proposals were made public, the Nikkei 225 rallied above the 13,000 mark in a Pavlovian response to government stimulus. But it is important to remember that Japan's declining population rates and reductions in industrial output over the last 20 years create limitations for the potential increases government stimulus can generate in nominal GDP growth.

While we might see some short-term improvements, the longer-term picture remains weak. The wider climate favors selling rallies in the broader indices like the Nikkei 225. Alternatively, investors should consider currency investments as the "carry trade" will likely generate increasing market buzz as the year progresses. With interest rates in U.S. currency holding at all-time lows, other options can be found in traditional high yielders, such as the Australian dollar.

Interest rates are 3% in Australia (nearly all of which will be captured when funding long AUD/JPY positions in yen). Fundamental support for these investments comes from the Australia's strong labor markets and rising inflation forecasts (which suggest that interest rates will need to be raised in the third or fourth quarter). Higher interest rates create bullish scenarios for currencies, allowing investors to reap gains in both interest rates and valuation changes. Overall, the scenario favors an avoidance of Japanese assets as the fundamental picture supports purchases made in currencies with superior interest rate potential.

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At the time of publication the author had no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

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