"Move along - there's nothing to see here"

If you play with dangerous things then eventually you're going to be at the scene of an accident and, true to form, the last two weeks have seen such an accident in bond markets - at least, there are those who would have you think so. The rise in yields in the U.S. and Europe has been greeted by a great deal of dismay and an even greater amount of extrapolation. And the cause of all this ire? A recent rise in U.S. long bond yields that, when viewed in a historical context, looks little more than a hiccup. It is tempting to say that, "this is only beginning" which isn't unreasonable but past experience shows that the new paradigm, the 'inactive central banker', subcontracts micro-economic management to the free markets - bonds, currencies and stocks. The ebb and flow of data within any period of time is therefore greeted with a series of mini-cycles (within the super-cycle) that keeps things in a 'metastable' equilibrium. In other words - things go up and down a lot, but don't do much besides create things for journalists to write about.

Part of the reason that we are currently going through a mini-cycle that is sending some commentators running around in circles while flapping their wrists up and down, is concerns over the end of quantitative easing (QE) in Japan. The fear is that this will reverse all those lovely capital flows that have supposedly supported western bond markets. Fears focus on the so-called 'carry trade', which allows investors to either borrow money in yen and buy higher yielding assets or endorses the kind of mathematics that allows Japanese investors to buy foreign bonds and take out the currency risk by hedging back into the yen and lock in a profit in the process.

The end of quantitative easing doesn't come as a real surprise to us. Back in November 2004, we wrote a piece called "Budget ZIRPless" (number 187), which predicted that the end of the zero interest rate policy (ZIRP) would be in February 2006 (which is kind of what is happening). The only thing we got wrong in that sense is that the end of ZIRP isn't an 'event' - it's a 'process'. From what you read in the papers, the end of QE could see interest rates rise in the next six months. But much of the hysteria surrounding this appears to come from a misreading of the actual statement made by the Bank of Japan.

(See http://www.boj.or.jp/en/seisaku/05/pb/k060309b.htm for the full text).

To summarise, the statement really says this:

It's a pretty woolly set of conditions, you'll agree, with lots and lots of wiggle room to do absolutely nothing for quite a long time. What's more you can understand it when CPI has only recently tipped over 0.5% (mostly because of fuel and energy costs) and is, in reality, hovering around zero percent ex-energy. This is not a strong case for putting up interest rates in the near future.

The BOJ will also have been disturbed by the notion that it could disrupt global capital markets if it makes a mistake that causes money to come flooding back to Japan, sending U.S. bond yields up, the U.S. housing market down and thereby reversing all of its good work. However, for those screaming that, "the carry trade doesn't work anymore," the reality is that, for Japanese investors, it hasn't worked for quite a long time. The mathematics of the situation changed last year when, finally, all of the value was drained out of it (see graph below) and buying U.S. Treasuries yielded precisely nothing. As we have shown in recent articles, the Far East and Japan stopped buying U.S. Treasuries a year ago and it has been the Europeans who have been keeping capital flows going to the U.S. In that sense, it is the European Central Bank not the BOJ that is the threat to the global money recycling problem.

Leaving that aside, as with its management of the yen, it is highly unlikely that the BOJ will allow the Japanese bond market to go into a price free-fall resulting in a global competition for money that sends yields higher in the rest of the world. It is much more likely that it will manage the markets with words and statements that ease tensions and fears as they arise in the coming months. This, in turn, creates a managed process that can be accommodated by all economies - not just Japan. Also it is much more likely to do nothing for a lot longer than people think (money markets already have a 0.5% rate rise priced in during the coming year) just to make sure that inflation really is back and anything it does will have little effect on the momentum of the economy. Unlike the U.S. Federal Reserve, which likes to be 'ahead of the curve', you could say that the Bank of Japan prefers being 'behind the curve'.

Once these complex factors have been taken on board, some of the market volatility created surrounding the BOJ meeting (see the New Zealand dollar and other smaller markets) should abate. It should also see the re-establishment of the carry trade mindset, which is likely to make the recent 'accident' in the bond and currency markets no more than a blip. As with any accident you always get ghoulish bystanders surveying the wreckage but like any good policemen would say they should be told to, "move along please - there's nothing to see here."