It's the punches you don't expect that hurt the most. While U.S. traders obsessed over the FOMC unwinding QE, the Bank of Japan came out of nowhere and pricked the bubble of Central Bank intrusion into markets.
Thursday saw Japan's Nikkei 225 (^N225) benchmark drop another 6.4%. The loss is the equivalent of nearly 1,000 Dow points. The Nikkei has lost more than 1/5th of its value since May 23rd. A 20% drop fits the technical definition of a Bear Market but don't be fooled. The Nikkei isn't slumping into bear territory. It's crashing.
Japanese stocks are collapsing despite active and massive intervention by its Central Bank. The Nikkei has now given back all but a fraction of the explosive gains made in the wake of Bank of Japan Governor Haruhiko Kuroda's public commitment to do whatever it takes to jump start the world's third largest economy.
Meanwhile yields on U.S. 10yr treasuries fell to just under 2.2% as focus on next week's Fed Meeting shifts from whether or not Bernanke will taper to whether or not the FOMC is as impotent as the BoJ seems to be.
Conventional wisdom has long held that Treasury rates would skyrocket as soon as QE was unwound. Ignored by most is the fact that long-held economic truths have been getting discredited one-by-one for five years. Inflation has not spiked. Deflation has been avoided. There hasn't been a meltdown, a bubble, or a recovery. As Japan illustrates, equities are hardly a sure thing either. Economists are fighting to take credit for scraps with the impotency of their "science" there for all to see.
So where does money go when all other markets fail? It goes to "risk-free" government securities. That means U.S. paper. The U.S. is the only non-emerging industrialized nation on earth with reliably positive GDP growth. The yield is almost nothing but that looks pretty good compared to the risk/reward profile of an investment in Japanese stocks.
Fed Chairman Bernanke has said repeatedly he'll be forced to tighten monetary policy if inflation exceeds 2% and/or the unemployment rate drops below 6.5%. Current levels for inflation and unemployment are roughly 2% and 7.6%, respectively. The Fed isn't going to stop the presses now that Japan is dropping into a sinkhole.
In light of what's happening in Japan, Fed "tapering" means nothing. The grim reality taking shape is that U.S. paper isn't priced as far off the free market rate as people think. A world so unsafe that getting 2% for 10-year treasury is a more frightening prospect than marginal tweaks to monetary policy by the FOMC.