Tuesday trade had two main moments of volatility, the first came from the RBA, and their decision to raise overnight interest rates to 3.75%, and the second came from the surprise Bank of Japan monetary policy decision to flood the commercial market with near-term liquidity.
Paradoxically, the two banks are at the opposite ends of monetary policy; the BoJ is looking to stimulate the economy in order to achieve inflation, while the RBA is looking to keep inflation under control.
The RBA raised rates by 25 basis points for the third consecutive month, suggesting that the bank is taking the inflation threat very seriously. Among the major economies, Australia was the only one that avoided recessions throughout the credit crisis, while the Reserve Bank of Australia is the only central bank that so far had raised rates.
To some extent this explains the performance of the Australian dollar since the beginning of the year, with a 31% gain on the Usd. The next major currency by percentage performance is the Canadian dollar, which has moved 16% since the start of the current year.
However, in Japan, things are completely different. At a time when the RBA is raising, the ECB is planning to announce its exit from the liquidity programs, and the Federal Reserve offers Quantative Easing-exit rhetoric with every public speech, the BoJ countered with a new $115 billion QE program.
The main reasons behind the Finance Ministry moves are the very strong Japanese yen, which recently has hit a 14-year high against the U.S. dollar, and the country’s fear of deflation. The BoJ will celebrate almost two decades in which the central bank has failed to spark any inflation, regardless of its tireless effort to revive the stagnating Japanese economy.
The BoJ seems unable to devalue its own currency, which by a long stretch, is a first among the central banking world. Some market commentators have called the BoJ the most inefficient central bank in the world because of their inability to spark growth, something that the iron fist of the Finance Ministry may soon swoop down to put right.
The phrase “the lost decade” became well-known in the financial industry due to the Japanese business cycle, and was used to describe the economy between 1990 and 2000, after a massive real estate/equity bubble collapsed. Unless the BoJ does something useful this time, the phase will soon become “the two lost decades”.
Deflation is a major threat to any economy, because it means that the money supply is falling, thus reducing overall business activity. Equity investors started to play this card recently, and since September have been reducing their exposure to the Japanese market.
In a period of time that global markets are characterized by a very high degree of correlation, the Nikkei 225 index has lost approximately 5% since September, while the S&P 500 index added 15%.
The BoJ policy actions will be reflected in the value of the Japanese yen and in the Nikkei index. The success of these unconventional policies will be assured when investors start once again investing in Japanese shares, while the Japanese yen will once again be used as a funding currency over the long run (read Carry Trade).
Until this happens, the BoJ has to struggle to fight deflation, and struggle to anchor market expectations – something that the bank never quite managed to do, after nearly twenty years of trying. The overnight session will be pivotal for the Nikkei to hold 9550, and for the Usd/Jpy to hold 86.50. Either one breaking down will signal more QE-based activity will soon follow.
Disclosure: No positions