Getting Jumpy

Just two weeks ago, this column discussed the threat posed by the increasing volatility characterizing the behavior of the Japanese financial markets. In the intervening period, two things have happened: there has been a dramatic increase in the degree of interest in and coverage of the Japanese markets, and those markets themselves have become still more volatile. Furthermore, that volatility has spread around the world, especially in bond markets.

In Tokyo, government bonds continue to sell off, with yields on the benchmark ten-year bond trading around 0.9%. That sounds very low and it is in absolute terms, but this is Japan, remember, and the yield on the ten-year bond at the end of march, before the Bank of Japan launched its new hyper-aggressive monetary policy, in which it committed to doubling its purchases of bonds, was only 0.55%. So the rise in yields (which means lower prices, remember – yields move inversely to prices)looks like a vote of no confidence by the market in that policy. Indeed, there are reports of Japanese institutional investors adopting a strategy of buying more assets overseas, to protect themselves from the plummeting value of the yen.

They seem also to be selling Japanese bonds, perhaps because they believe – or at least fear – that the declared policy of creating inflation will succeed. If deflation (falling consumer prices) is replaced by actual inflation(rising prices), then bond yields will have to rise to reflect this – and that is the trap implicit in the government’s policy: if it succeeds in breaking the deflationary spiral, that may come at the cost of triggering a sharp rise in bond yields. If so, the higher borrowing costs will push the hugely-indebted government over the edge and into bankruptcy.

In any event, the selling pressure on bonds is such that the Bank of Japan has had to intervene several times to ‘calm’ the market, by injecting extra liquidity – meaning that it buys even more bonds itself, thereby stemming the tide of selling But the nervousness apparent in the Japanese bond market has spilled over, into the domestic equity market – where the seemingly-endless rise in prices has forcefully reversed this week, with drops of 7% on Tuesday and 5% on Thursday – and the foreign exchange market, where the yen’s steady decline has been arrested around the level of 103 to the dollar and the currency has actually dropped back (its value has risen) to almost 100.

But that is hardly all. As noted, the nervousness has spread far beyond Japan. In Europe, the remarkable recovery in the government bonds of the hardest-hit countries, led by Greece but also including Spain and Italy – which seemed to have been fuelled by the flood of money released by the Japanese central bank, has abruptly reversed course. Greek government bond yields have soared and the Athens stock exchange, which looked to be on the way to the moon, has crashed over the past fortnight. But these ‘peripheral’ countries are of secondary importance. What really stands out is the sharp rise in yields (i.e. fall in prices) of government bonds in the top-flight countries – Germany, the UK, even Switzerland – and, perhaps especially, in the US. The sharp rise in the yields on government bonds of ten-year and longer durations in all of these countries stands in stark contrast to the efforts of their central banks to hold short-term interest rates at or near zero and to pressure long-term rates downwards.

In the US, the rise in yields has been attributed to one or both of two factors. In the best case, which is the scenario preferred by most of the big institutions, higher yields reflect the improvement in the economy and the expectation that this will continue. Alternatively, the rise in yields may be a response to the growing debate regarding how long the Federal Reserve will maintain its current policy to buy $85bn worth of government and other bonds every month. Clearly, any reduction in this amount must be detrimental to the bond market, hence the nervousness.

However, the fact that the rise in bond yields is a global phenomenon suggests that it has a common cause. It would be natural to think that this cause should be sought in the US – but it is increasingly believed that the driving force behind the disquiet in global markets is now Japan. Although Japan is only the third-biggest economy in the world and its bond market is second to that of the US, the size of the waves being made by the new government policies there make that country the source of the volatility now being experienced. Unfortunately, because confidence in the Japanese government’s ability to succeed in its very ambitious goals is low both in Japan and around the world, the degree of jumpiness is unlikely to subside — and may well increase.

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