Bank of Japan Gives Australia More Rope

Remember in Friday’s Markets and Money I said to keep an eye on the closing price of the ASX 200? Here’s what I wrote:

Being the last trading day for the month, it will be interesting to see whether the ASX 200 will close back above the 5,000 level. If it can’t (future prices indicate it will struggle) it will represent the lowest monthly close since June 2013.

Well, late in the day the index was lacklustre. But then came the Bank of Japan with its negative interest rate announcement. The Aussie index responded immediately. Stocks closed up on the day and the ASX 200 closed just above 5,000.

But was it enough?

Not quite. Friday’s close was slightly lower than the August monthly low. That means the Aussie market made a new monthly low in January, the lowest monthly close in three and a half years.

That’s bearish. It tells you that the odds suggest this market will go lower as 2016 unfolds.

But in the short term, the bounce that got underway last week should continue for a while yet.

Thanks to the Bank of Japan’s actions on Friday, Aussie stocks should continue to rally.

So what did the BOJ do? Bloomberg explains:

The Bank of Japan pushed interest rates below zero Friday, after years of keeping them at the lower end of the positive range.

The negative rates will be imposed on reserves worth about 10 trillion to 30 trillion yen initially and will apply only to new reserves that financial institutions deposit at the central bank, according to people familiar with knowledge of the matter. The change will take effect on Feb. 16.

Let’s ignore the fact that this will do absolutely nothing to help Japan out of its economic quagmire. The country is stuck in some sort of deflationary vortex, driven by horrible demographics.

With Japan’s population constantly shrinking (meaning constantly lower demand) no amount of monetary or fiscal stimulus will fix things.

This policy decision is all about trying to weaken the currency. I wonder what China will think of it?

But in the short term, such a move is bullish for markets. To understand why, let’s have a look at the role that Japan plays in global asset markets.

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As you probably know, Japan has been a basket case for many, many years. Thanks to a massive asset market bubble at the end of the 1980s (which the authorities never dealt with properly) and terrible demographics, Japan has endured years of very low interest rates.

As a result, one of the primary big picture trades has been the selling of Japanese yen and the buying of higher yielding currencies and assets. Australia is one of the favoured destinations of Japanese capital.

In fact, there is a pretty strong correlation between the Aussie stock market and the Aussie dollar/yen exchange rate. The chart below shows you this relationship over the past five years.

The All Ordinaries index is the black line, while the Aussie/yen exchange rate is the red line. When the yen weakens, it’s bullish for Aussie stocks because investors and traders sell it to buy higher yielding Aussie assets.

Source: StockCharts

So this announcement by the BOJ should provide a short term boost for Aussie stocks. But it will only be short term.

After all, what have negative rates achieved for the Swiss or Europeans?

These are policy settings designed to discourage capital flows and weaken currencies. Nothing good comes out of deliberate attempts to devalue currencies. Such policies are an admission that there are no other options to increase demand…the only option is to steal existing demand from other nations.

It also raises the question of when the Fed will respond. The interest rate settings of Japan and Europe funnel capital into the US dollar where there is at least the whiff of a yield. The strength of the dollar will eventually hurt US multinationals. In fact, it’s already hurting them. Falling earnings estimates for US stocks reflect this.

Now, this is good and bad news for Australia. It’s bad in that a stronger US dollar usually reflects weaker commodity prices. That should keep a lid on any recovery in the resource sector (notwithstanding the rally in oil).

But negative rates in Japan should see some short term support for the banks, as capital searches for a return in this higher yielding sector.

As I mentioned though, this will only be a short term reaction. There are some bearish big picture developments unfolding in the global economy. This announcement by the BOJ will not change that.

The other thing to consider is that it is really only ‘saving nations’ that can set interest rates below zero. Both Japan and Europe have huge levels of excess savings (a result of running current account surpluses for years) and this puts constant upward pressure on a currency.

Setting negative rates is one way of removing some of this upward pressure.

But if Australia tried to do something similar, it would risk a currency collapse. We are a debtor, not a creditor. Who would want to invest in Australia for near zero return?

No one. After hedging for currency risk, it wouldn’t make sense.

So the best we can hope for is to take advantage of the desperation of the world’s savers to weaken their currencies. But will only buy us a little more time.

Or, depending on your viewpoint, provide us with a little more rope to hang ourselves with.

Greg Canavan,

For Markets and Money

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Greg Canavan
Greg Canavan is a contributing Editor of Markets and Money and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to Markets and Money for free here. If you’re already a Markets and Money subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Markets and Money emails. For more on Greg go here.

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