MW-50 -- Caution: Slippery when Excessively Liquid

J@pan Inc Magazine Presents:
Weekly Financial Commentary from Tokyo

Issue No. 50
Tuesday, October 28, 2003

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++ Viewpoint: Caution: Slippery when Excessively Liquid
The Bottom Line:
Top-Down: Inflationary expectations take a 180-degree turn.
o When Japanese government bond yields hit bottom below 0.50
percent in the second quarter of this year, they effectively
were discounting deflation for the next 10 years. Now, it
seems investors are increasingly nervous about the next shift
in monetary policy, ostensibly as central banks react to
inflation, not deflation.

o The Bank of Japan is trying to toe a fine line on two fronts.
Given the "deal" reluctantly made with the US, Japan's
authorities not only are inhibited from intervening to support
the yen but even from talking the yen down. At the same time,
they need to reassure market participants that they are
nowhere near a shift of gears on monetary policy, despite
recent evidence of abating deflation.

o Yet given comments by US treasury secretary John Snow about
interest rates, and the "near miss" rate rise at the Bank of
England, investors are ultra-sensitive to exchange-rate
volatility and hints from the US and the UK that a tweaking of
monetary policy may be at hand.

* Bottom-Up: The recent sell-off in Japan hits financials; time
for a gear change?
o The three-day sell-off in Japan hit the financials the hardest
and may be a hint of what to expect should a full-fledged
consolidation develop. As the driver of stock prices shifts
from excess liquidity to earnings, markets inevitably

o The only sector that held up was the pharmaceuticals, which
have been sitting on the sidelines so far in this rally. If
the consolidation lingers, one might want to buy some
defensives as "insurance." There is little relative downside
risk in defensives such as pharmaceuticals.

o Metal stocks have been outperforming the Topix, and we think
there is more to come, especially if we are on the cusp of a
secular bull market in commodities, as we believe we are.
These stocks are taking their cue from overseas peers such as

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++ Viewpoint: Caution: Slippery when Excessively Liquid

Recent sell-offs in equity markets around the world had investors
wondering if the weakness was merely an "air pocket" in a developing
bull market or a "gear change," with the markets preparing to change

When Japanese government bond (JGB) yields dipped below 0.50 percent
in the second quarter of this year, they effectively were discounting
deflation for the next 10 years. Now, it seems, investors and analysts
are suggesting that the end of deflation in Japan is near or at least
closer than the 10 years forward that was previously being discounted.

In January of this year, prime minister Junichiro Koizumi called
falling prices Japan's "most urgent policy task" and declared that he
was taking all possible steps to curb its ravages. Such posturing drew
praise from experts ranging from Japan's economics czar, Heizo
Takenaka, to Glenn Hubbard, former chairman of the US President's
Council of Economic Advisers.

But by October of this year, Takenaka, while not giving a specific
date, was suggesting that the end of deflation was "very near."
However, the emergence of inflationary expectations put the Bank of
Japan (BOJ) in a delicate position.

According to BOJ governor Toshihiko Fukui, Japan investors can expect
a "positive economic activity cycle" to emerge. "The foundations for a
gradual recovery in Japan's economy are being laid as a result of
improvements in corporate sentiment and the environment for exports,"
said Fukui at a BOJ branch managers meeting in October. Yet the BOJ's
price outlook is a scenario for deflation to continue through fiscal

At the October 10 Policy Board meeting, the BOJ reiterated its pledge
about consumer price index (CPI) levels and the need to see credible
forecasts of price increases before changes will be considered, while
at the same time emphasizing the bank's commitment to its current
historically loose "easy money" policies.

From November, the central bank will also drop the use of "upward" or
"downward" revisions in its economic assessment and instead begin
describing economics as better, worse or in line with economic
scenarios as indicated in the bank's market outlook reports.

All this appears to be aimed at quashing market suspicions that the
BOJ may be considering a tightening of its historically unprecedented
loose monetary policy. These suspicions were fostered by a CPI decline
that narrowed to -0.1 percent in August and the expectation that
Japan's CPI could turn positive in October, as was hinted at by

In addition, the BOJ is trying to toe a fine line on shifting
expectations for the yen-dollar exchange rate. While the bank was
pouring a massive 13.5 billion yen into the currency markets to
keep the yen from appreciating further, and Japanese government
officials were using every chance they had to talk down the yen,
they have become curiously silent since the pronouncement on desired
currency alignments following a meeting of the Group of Seven (G-7)
nations in late September. In keeping with this newfound "jisshuku"
(self-restraint) on verbal and actual intervention in the currency
markets, the central bank has apparently become much more cautious
about what it says about the strong yen.

The first source of this sensitivity is the US's transparent effort to
give lip service to a "strong dollar policy" while actually actively
working for a weaker dollar.

Several weeks ago, US Treasury Department spokesman Rob Nichols was
quoted as saying that "we are not going to respond to every goofy
market rumor on currencies," when asked if the Bush administration had
changed policies on currencies -- "of course there is no change in

But actions speak louder than words. It is increasingly obvious that
the US is trying to strike deals with Japan and China in exchange for
their tacit "benign neglect" of their currencies, ostensibly to allow
them to gradually appreciate against the US dollar.

One signal was the G-7 pronouncement, which was seen in some circles
as a success for the US in its efforts to try to get a united front
together to discourage even more intervention by Japan and to get
China to allow the yuan to appreciate. To follow up, Treasury
secretary John Snow was on the plane to Tokyo and China.

Japan has also apparently been recruited as a reluctant player in a
US strategy aimed at US voters. After president Bush's visit to Japan
and Asia, BOJ governor Fukui will be going to China to see Zhou
Xiachuan, governor the People's Bank of China, while the deputy
governor of the Bank of China will visit Japan in November.

The second source of sensitivity are signs that the G-7 central
banks and governments are plotting the end of "deflation watch"
measures in favor of "inflation watch" policies.

Treasury secretary Snow, in his eagerness to put a positive spin on
the US economic recovery and job prospects for a domestic audience,
shocked financial market participants by stating that he would "be
frustrated and concerned if there were not some upward movement" in
interest rates.

Pouring salt in the wound, Snow also appeared to reject the idea that
the Federal Reserve would not raise interest rates before a
presidential election. "It is amazing how you get this sort of
mythology without any factual backing," he said.

At the October meeting of the Bank of England's Monetary Policy
Committee, a proposal to raise rates by 0.25 percentage points was
narrowly defeated by one vote; this revelation shook the London market
for two days. It won't take much more positive economic news for the
committee to vote for higher rates in November.

Gear Change?
Money Watch believes that the ultra-sensitivity to exchange-rate
volatility and the prospect of a US dollar rout, as well as the
inevitable "normalization" of monetary policies in Japan and the
US, has investors wondering whether the recent sell-offs in the
US, Japan and other global equity markets are merely an air pocket or
a more enduring change of market gears. To Money Watch, the equity
markets appear to be trying to shift from being driven primarily
driven by excess liquidity and ultra-loose monetary policies to
earnings fundamentals, namely, profit growth. The one problem with
this transformation is that it has inevitably led to an interim
correction, the length and depth of which is dependent on the balance
of interest rates, monetary policy and earnings recovery.

-- Darrel Whitten

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Written by Darrel Whitten

Edited by J@pan Inc staff (


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