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"Free markets for Free men" is the battle cry for traders on Chicago's futures markets. But if you want to trade proxies for Japan’s Nikkei-225, such as ETF’s (NYSEARCA:EWJ) and (NYSEARCA:ITF), or the Japanese yen, be prepared to do battle with Tokyo’s warlords at the Ministry of Finance [MOF]. Meddling in the local markets is a time honored tradition at Japan’s MOF, and there is no limit to how far Tokyo will go when it comes to market intervention to support the aims of its big industrialists and banks.

For instance, when the Nikkei fell below the psychological 10,000 in February 2002, former MOF chief Masajuro Shiokawa drew up plans to buy 2 trillion yen of stocks directly from banks, and ordered the Bank of Japan to increase its monthly bond purchases to 1 trillion yen to drive bond yields lower. The MOF bought Nikkei futures contracts, squeezing short sellers ahead of the March 31st, fiscal year end.

Shiokawa then tightened short-selling rules and increased surveillance of bearish foreign brokers who accounted for half of the average daily trading volume on the TSE. Scrolling forward to 2006, with the Nikkei gyrating in the 14,000 to 17,500 range, Tokyo keeps close tabs on the Japanese yen /dollar exchange rate, and has pursued a cheap yen policy to indirectly support the Nikkei.

Tokyo Infates Nikkei-22 with Weak Yen

In the biggest intervention operation in financial history, Japanese authorities sold a record 20 trillion yen in 2003 and another 15 trillion yen in the first three months of 2004, to purchase $300 billion US dollars, and prevent the greenback from falling below 102-yen. The intervention began to bear fruit in 2005-06, when Federal Reserve rate hikes to 5.25% lifted the USD from 105-yen to as high as 120-yen.

Tokyo Engineered cheap yen policy to boost Nikkei-225

The dollar’s rise to 120-yen inflated profits of Japanese multinationals such as Toyota Motor (NYSE:TM) and Honda Motor (NYSE:HMC). Toyota’s annual operating profit gains about 35 billion yen for every 1-yen increase in the value of the US dollar. Toyota Motor’s first-quarter profit rose 24% to 330 billion yen [$2.88 billion] for the three months ended June 30th, after boosting sales in the US by 12 percent.

Honda’s fiscal Q1 profit surged 30% to a record 143.4 billion yen, helped by the weaker yen. Honda earns 85% of its revenues in US dollars. Meanwhile, General Motor’s (NYSE:GM) loss in the second quarter of 2006 was $3.4 billion after the automaker took a charge to eliminate 34,400 jobs. Toyota increased its US market share in June by 2.3% to 15.3% from the same period a year ago, while GM dropped 3.7% to 24.5 percent. Honda gained 1% to 9.2% in the same period.

Japanese Exports to China are Key Driver for Nikkei-225 Stocks

Because the Chinese yuan is tightly pegged to the US dollar by Beijing, Tokyo’s efforts to weaken the yen boosted exports to China, its second-biggest overseas market after the US, to 984 billion yen in October, the highest ever, led by demand for electronics and steel. Sino-Japanese bilateral trade enjoyed growth of 11.8% in the first eight months of this year, compared with an annual rise of just 9.9% in 2005, but less than annual growth of 25.7% in 2004.

But Japan’s cheap yen policy to boost the Nikkei-225 may have reached a dead end on October 23rd, when Hiroshi Watanabe, Japan’s FX chief told reporters in New York, “I see no reason for a further deterioration in the yen given the strength in the Japanese economy,” freezing the dollar’s rally at 119.50 yen, and giving traders the green light to knock the dollar to as low as 116-yen a week later.

On Nov 11th, General Motors’ Rick Wagoner and fellow chieftains from Detroit’s Big Three automakers complained to President George Bush that “the Japanese yen is systematically undervalued, which helps Japan to maintain significant trade balance surpluses in our industry. We are willing to make difficult decisions to transform our businesses to compete successfully, but can’t counter the effects of an excessively weak yen. We asked Bush to take action to address the weak yen,” Wagoner said.

Interest rate differentials turning against US dollar

G-10 central bankers are now calling on the Bank of Japan [BOJ] to tighten its monetary policy further, to discourage carry traders from borrowing yen, and reinvesting the funds in inflation assets around the world. European bankers also object to unilateral ECB rate hikes without similar moves by the BOJ, which could exert further upward pressure on the Euro beyond 150-yen, already at 8-year highs.

The BOJ has left its monetary policy unchanged after hiking its key overnight call rate target to 0.25% in July, the first rate hike in six years.

“I told the G-20 that the Japanese economy continues to expand steadily, amid stable prices. If this trend continues, we will adjust monetary policy gradually, looking at various risk factors ahead,” said BOJ chief Toshiro Fukui on Nov 20th.

On Nov 30th, Bank of Japan Policy Board member Tadao Noda added, “If the economy and prices are moving in line with our outlook report, the BOJ will slowly adjust interest rates, watching the economy and prices. If we do not adjust interest rates in accordance with such conditions then much larger adjustments will be required down the line. This will lead to fluctuations in economic activity and increase the possibility of impeding long-lasting growth of our economy,” he said.

US Bond Yields Shrinking Relative to Japanese Bond

Japan had 765 trillion yen in sovereign marketable securities, or $6.5 trillion, outstanding at the end of June 2006, compared with $4.3 trillion in the US Treasury market. Since then, the spread between the US 10-year yield and the Japanese 10-year yield has narrowed 54 basis points to 2.82%, making US bonds less attractive to Japanese investors and starting to weigh on the dollar /yen cross rate.

On Dec 5th, BOJ chief Fukui Fukui will hold a meeting with Prime Minister Shinzo Abe, Finance Minister Koji Omi, Chief Cabinet Secretary Yasuhisa Shiozaki, and BOJ deputies Toshiro Muto and Kazumasa Iwata. “It’ll be a venue for free exchange of opinions,” Shiozaki said. But on Dec 1st, Economics Minister Hiroko Ota said it was up to the Bank of Japan to decide whether to raise interest rates, a signal that Tokyo is relenting to a quarter-point rate hike sometime in January to March.

USD Topping Out Vs. Japanese Yen as Traders Anticipate 2007 Fed Rate Cuts

But while the BOJ is laying the groundwork for a rate hike as early as January, US Treasury bond traders are betting the Federal Reserve could start lowering its federal funds rate by as much as 75 basis points to 4.50% in the first half of 2006. That would narrow the US dollar’s interest rate advantage over the yen, and unravel a key prop that has inflated Nikkei export earnings from China and the US.

On Dec 1st, the US national factory index dropped to 49.5 from 51.2 in October, the first time the index had fallen below 50 since April 2003, which indicates a contraction of activity in the sector. A dip below the critical 50 mark has historically been a reliable harbinger of Fed rate cuts. The last four Fed monetary easing cycles began on average three months after sub-50 readings on the factory index.

Nikkei-225 Tracking Trends in Japanese Yen vs. USD

For most of the past 16-months, the Nikkei-225 has closely tracked the Japanese yen /US$ exchange rate. However, an unusual divergence occurred in the week ended Dec 1st, when the Nikkei-225 jumped 600 points to the 16,300 area, after the US dollar tumbled 2.5-yen to 116.35-yen. On Nov 21st, the LDP’s tax czar Yuji Tsushima, spoke out against ending temporary tax breaks on stock investments, saying it would hurt the stock markets, at a time of imminent BOJ rate hikes.

Preferential tax treatment for capital gains and dividends on Japanese stocks was introduced in 2003 for a period of five years to support the faltering stock market. Tokyo cut the tax rate on capital gains to 10% from 20%, but the tax break is due to expire at the end of 2007. The reduced tax rate on dividends is set to expire at the end of March 2008. Mr Tsushima’s comments were perfectly timed to support the Nikkei index at key horizontal support at the 15,600 level.

Still, Tokyo’s latest scheme to support the Nikkei-225 could falter if the yen strengthens against the Chinese yuan and the US dollar. Japanese FX chief Watanabe said the two big risks for the Japanese economy in 2007 would be a revival of geopolitical tensions in Iran [i.e. higher oil prices] and North Korea, or a slowdown of the Chinese economy. “We are very much cautious about China, there is a risk of a re-adjustment in the Chinese economy” next year.

Source: Japan's Nikkei-225 and the Dollar/Yen Dance