MKT OUTLOOK FOR 0221: Will Japan’s Rate Decision Move the Mkt?

For 0221, everybody is thinking of Japan CB’s rate move. But mkt seems not nervous at all today: Yen is actually down, and Dow closed up almost 20 points, bonds closed up as well with TNX going down 1 basepoint.

Guessing from those barometer readings, even Japan CB raises rate tomorrow, it would not move mkt very much. But if not, would bull take over the ball and run again? In that case, trader has to be careful in shorting from “resistance”. Instead, long at “support” may have better chance of winning.

So, what’s the deal on Japanese rate? And more importantly, what mkt is thinking about it?

Let’s start from deflation.

Japanese CB thinks the deflation, which has trapped Japanese economy since early 1990s, has ended now, or is of a much smaller probability for it to come back. So JCB ended its 5 Y  “quantitative easing” in 032006, and actually raised the rates 072006, 1^st time since 082000.

1.       What is deflation?

(Some of the following is quoted from” wikipedia”)

 Deflation is a decrease in the general price level, over a period of time. The 'general price level' comprises the price of wages, consumption goods and services. In monetarists theory, deflation is defined in terms of a rise in the demand for money, based on the quantity of money available. The Quantity Theory of Money is founded on the Fisher equation (also called the equation of exchange),

MV = PT, [1]

where M is the money supply, V is the velocity of money, P is the average price level and T is the total number of transactions.

In this model of deflation, it is a contraction of the money supply which reduces the velocity of money, and thus the number of transactions falls and therefore the general price level falls in response.

What happened in Japan is almost a classic textbook example:

Systemic reasons for deflation in Japan can be said to include:

• Fallen asset prices. There was a rather large price bubble in both equities and real estate in Japan in the 1980s (peaking in late 1989). When assets decrease in value, the money supply shrinks, which is deflationary.

• Insolvent companies: Banks lent to companies and individuals that invested in real estate. When real estate values dropped, these loans could not be paid. The banks could try to collect on the collateral (land), but this wouldn't pay off the loan. Banks have delayed that decision, hoping asset prices would improve. These delays were allowed by national banking regulators. Some banks make even more loans to these companies that are used to service the debt they already have. This continuing process is known as maintaining an "unrealized loss", and until the assets are completely revalued and/or sold off (and the loss realized), it will continue to be a deflationary force in the economy. Improving bankruptcy law, land transfer law, and tax law have been suggested (by The Economist) as methods to speed this process and thus end the deflation.

• Insolvent banks: Banks with a larger percentage of their loans which are "non-performing", that is to say, they are not receiving payments on them, but have not yet written them off, cannot lend more money; they must increase their cash reserves to cover the bad loans.

• Fear of insolvent banks: Japanese people are afraid that banks will collapse so they prefer to buy gold or (United States or Japanese) Treasury bonds instead of saving their money in a bank account. This likewise means the money is not available for lending and therefore economic growth. This decreases the supply of money available for lending and economic growth. This means that the savings rate depresses consumption, but does not appear in the economy in an efficient form to spur new investment. People also save by owning real estate, further slowing growth, since it inflates land prices.

• Imported deflation: Japan imports Chinese and other countries' inexpensive consumable goods, raw materials (due to lower wages and fast growth in those countries). Thus, prices of imported products are decreasing. Domestic producers must match these prices in order to remain competitive. This decreases prices for many things in the economy, and thus is deflationary.

2.      Has deflation ended for Japan, as its CB thought?

According Stephen S. Roach of MS

“Even now -- fully five years into economic recovery -- Japan has yet to distance itself from the risks of a deflationary relapse.  The nationwide CPI is in positive territory only by the slimmest of margins (+0.1% y-o-y in January 2007), and is actually threatening to slip back into negative territory within the next month or so especially if it turns out to be more of a cyclical rebound than a structural healing. “

That is why Japanese Gov is pressuring its CB not to raise rate.

3. Mkt’s Thinking

So, I guess mkt’s thinking now is: what’s the big deal, even Japan CB raise by 0.25% to 0.50% on 0221? The rate is so low anyway and it’s still disputed whether Japan has come out of the deflation trap. There had been many false “breakout” in this regard in the past. Anyway, there is not much upside risk regarding Japan rate for the near future. With rate raise or not this time, carry-trade will be carried on

4.      What about US rate?

Concern over the direction of Fed’s next rate move is and will be an overhang on mkt, until Fed is not ambiguous anymore about its policy. Japanese’s long battle with deflation reminds people about 2003 in US. In 2003, when core inflation gauged by the PCE price index drifted to and below 1%, Fed eased aggressively to avoid even a small threat of deflation.  

Deflation is not a threat to US economy now. But economy is still weak, and could slump for worse significantly if there is an external shock such as terrorist attack. Will US economy be resilient enough to go back to its 3% real GDP growth rate by itself? Is inflation tolerable at 2%?  Would that provide enough cushions against  deflation? Does Fed need another hike just to be conservative in reducing inflation threat? Or would that hike be too much for us economy to handle it?

Particularly in the context of today’s asset or debt-dependent US economy, Fed has to think really hard before raising the rate.

I guess mkt has made up his mind, that is: 2% inflation is tolerable, and a rate reduction will help kicking economy back into its 3% real or 5% nominal annual growth, or at least not raising the rate. We still have time, and mkt seems happily patient.    

Last, speaking of “MV = PT”, let me make my solute to Milton Friedman. Milton Friedman died last year in San Francisco, not far away from where I live. Milton Friedman, along with Keynes, made great contribution in helping understanding modern capitalist economy. Milton Friedman’s “quantity theory of money” educated an entire generation of economist and central bankers, among them are Paul Volcker , Alan Greenspan, and Ben Bernanke.