The Bank of Japan Opts Out, is China next?

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My take: This is an interesting take by Gary North. The most obvious question Gary didn't truly ask was, "What happens if China opts out?" To the question, "What happened to Asia's stockmarkets?" -- there is an answer. It may not be the bestanswer, but it makes sense to me. The Bank of Japan is inthe process of abandoning its policy of zero interestrates. This policy has subsidized Japan's ailing commercialbanking system, which is still sitting on a pile of badloans left over from the 1990s. It has kept equity priceshigher than would otherwise have been the case. The samegoes for property prices. Yet both markets fellsubstantially in the 1990s. The legend of Japanese deflation is inaccurate. Japan's retail prices had slightly down years and slightlyup years through the 1990s. See the chart, "Inflation." As you can see, price deflation was low whenever itexisted, which was infrequently. From 1990 until 1995, theconsumer price index was positive except briefly in 1995. It moved up in 1997 to about 2%. Then it moved down in theaftermath of the Asian currency crisis of 1998. In thisdecade, price deflation never got more than about 1%. This should warn you: Do not take seriously theheadlines of roaring price inflation as the cause of therecent fall in the U.S. stock market, any more than youshould take seriously stories of roaring price deflation inJapan. Ambrose Evans-Pritchard's article in the May 29 issueof "The Telegraph" reported on a shift in policy by theBank of Japan. Governor Toshihiko Fukui has bled more than $140bn from his banking system since March 9 to reduce a menacing overhang of liquidity left from the battle against deflation. He is halfway through. No longer buying fistfuls of US Treasuries with printed money to hold down the yen, the Bank of Japan has been the silent force pushing up global bond yields this year by 0.8pc -- the jump that really lies behind the market rout. It is possible for the bond market and the stockmarket to rise or fall together. They rose together in theUnited States from 1982 until 2000. They are now fallingtogether in Asia. Japan's central bank is now selling dollars. Japanese holdings of US Treasuries have fallen by $74.5bn since December. "We are reaching an inflection point in monetary policy," said Mr Fukui. In other words, the subsidy provided to the U.S.government's debt market by the Bank of Japan has ceasedfor the time being. Yet this has been the most importantsubsidy for this market for the last decade. This has ominous implications for the yen carry trade. For almost 15 years, the Bank of Japan has subsidizedlarge-scale speculators, who borrowed yen at almost 0%,bought foreign currencies, and then bought debtobligations, especially bonds. This was easy money on amassive scale. When you can get free money, you aretempted to do it again and again. But then comes the dayof reckoning. As Evans-Pritchard puts it, Hedge funds that had borrowed for zilch in Tokyo, to lend for a fat premium to overheating Iceland and New Zealand, began rushing for narrow exits. The storm has since swept up much of the globe, setting off the steepest falls in emerging market stocks and bonds since the Russian default in 1998. "Most people underestimated the effects of monetary tightening in Japan," said Phillip Poole, an economist at HSBC. "The liquidity that has driven these markets is being withdrawn." This policy of Japan has an acronym: ZIRP (zerointerest rate policy). This policy is now coming to anend. Few investors lose sleep worrying about life after zirp, but our guardians at the Bank of International Settlements view it as the greatest imminent risk to global markets. Adding to the threat of worldwide recession, theEuropean central bank is also tightening money. TheEuropean housing bubble has created concern over risingprice inflation, which is driven by rising real estateprices. Judging by the apocalyptic tone of the Bundesbank's May report, Europe is on the brink of a monetary shock going far beyond the mincing half-measures trickled out until now by Jean-Claude Trichet, ECB chief and French "soft euro" inflationist. Evans-Pritchard refers to the German central bank(Bundesbank) as Buba. It reminds me of that mythicalAmerican redneck, Bubba. Germany is back, and a reawakened Buba is snorting with the same bloody-minded determination it displayed before causing the 1987 crash and the 1992 bust up of the ERM (European Exchange Rate Mechanism]. This threat of rising rates threatens the U.S. dollar. If Japan allows rising short-term interest rates, andEurope allows rising short-term interest rates, the dollarwill come under selling pressure. To keep the value of thedollar high, the Federal Reserve will have to retain itspresent flat-reserves policy, thereby letting short-terminterest rates rise. This is bad news for the ARM [adjustable ratemortgage] market and the housing market generally. Evans-Pritchard's analysis is spot-on. Ben Bernanke was back-peddling fast in a letter to Congress last week, pleading that core CPI inflation "overstates" price rises. "Monetary policy must be forward-looking," he said. Has the Fed already gone too far, baking a recession into the pie? Will the delayed effects of past tightening kick in, with mounting ferocity, just as the housing boom plummets into bust? "Housing mayhem seems unavoidable. The US hard landing begins now," said Charles Dumas, global strategist at Lombard Street Research. Mortgage applications are down 17pc in a year. House sales are down 5.7pc, and inventories of unsold new houses are at their highest since 1996. The central prop holding up the US consumer boom is crumbling, leaving behind record household debts equal to 127pc of disposable income. Short-term rates and bond yields in Japan have been negligible for so long that investors take them for granted. Japanese recoveries tend to fizzle faster than they emerge. The Bank of Japan hasn't built much credibility in markets, having failed for some 15 years to stabilize growth and avoid deflation. Yet Japan's long-awaited return to the economic plus column is here. And even if the country doesn't grow 5 percent a year, there can be little doubt that the BOJ will raise rates from zero percent. The central bank is keen to return some normalcy to Japan's monetary policy. Global markets have been slow to grasp the specter of higher Japanese rates. In recent weeks, though, surprisingly large moves in markets from Iceland to Turkey to India have been partly attributed to the unwinding of yen trades. And where yen-volatility is concerned, we probably haven't seen anything yet. The worldwide housing boom has rested on the Bank ofJapan's monetary expansion and the parallel expansion bythe other major central banks. Now this is ending: inJapan, in Europe, and in the United States. Today's financial press wailing about U.S. priceinflation will be replaced by wailing about a worldwiderecession. What happened to Gerald Ford's 1975 WIN program(Whip Inflation Now) should remind us: Recession can followthe next year. That reversal cost Ford the Presidency. Pesek worries in print that no one knows how big theyen carry trade is. What makes the yen-carry trade so worrisome -- and easy to dismiss as a potential problem for markets -- is that no one really knows how big it is. It's not like the BOJ has credible intelligence on how many companies, hedge funds or mutual funds borrowed in yen -- or how much -- and put the money into assets elsewhere. It would be more comforting if the Bank for International Settlements, the International Monetary Fund or the Federal Reserve Bank of New York had a better handle on all this. Who really knows how many purchases of Shanghai properties, Google Inc. shares, Zambian treasury bills, bars of gold or derivatives are related to yen borrowings? The American investing public has not yet got themessage. Few invesrors have heard of the carry trade. Fewfund managers are prepared for its potential negativeconsequences. The central banks are now reversing adecade-old policy. I don't think they will maintain this disinflationasrypolicy, once it becomes clear that the carry trade isunraveling and taking the equity markets and the realestate markets with it. But whenever the major centralbanks pursue the same policy, there is going to besimultaneous trouble.