Japan Policy Shift May Set New Tone

Japan Policy Shift May Set New Tone

Expected Tightening Stance
Could Affect World Markets;
Change Likely to Be Gradual
By LAURENCE NORMAN
February 25, 2006; Page B5

NEW YORK -- Wind up your watches and start the countdown. The Bank of Japan is about to start a process that could ripple through global capital markets for years to come.

After more than a decade of near-zero interest rates and five years of "quantitative easing -- the injection of trillions of excess yen into the banking system to defeat deflation -- BOJ officials have sent strong signals recently that they are ready to start tugging at the reins of monetary policy.

Yet patience will be required. With the pace of the policy shift likely to be glacial and the timing of watershed changes uncertain, analysts warn it could be years before the full impact is revealed.

The gradual removal of ultraloose policy from the world's second-largest economy "is one of the great stories over the course of the next three or four years" for financial markets, said Jack Malvey, chief global fixed-income strategist at Lehman Brothers in New York.

"The capital flow implications, the effect on U.S. interest rates, on Japanese domestic markets are all to be sorted out."


If Japanese rates rise, this money could start to return home. Meanwhile, foreign investors, who have already been drawn to the fast-rising Nikkei equity index, could begin investing more broadly in Japanese assets.

Mr. Malvey said this could send U.S. interest rates higher and the dollar lower, as Japanese private investors shift away from U.S. assets. It could also result in higher consumer spending in Japan and a lower Japanese current account surplus, boosting global growth.

The yen could appreciate across the board, as negative bets -- against the euro, the New Zealand dollar and other high-yielding emerging-market currencies -- are unwound.

However, David Abramson, global strategist at Bank Credit Analyst Research in Montreal, said there are a number of uncertainties that cloud the impact of what he calls "the mother of all [policy] normalizations."

In the short term, he said no one quite knows the extent to which investors have taken advantage of Japan's ultraloose policy to borrow in yen and buy other assets.

"There's a lot of liquidity around the world and some of it is because Japanese rates...are still very low. We just don't know the size" of these investments.

In the longer term, it is still unclear how long the BOJ will take to completely remove quantitative easing, when the bank will lift interest rates or whether an eventual rate-tightening cycle would be brief or protracted.

Mr. Abramson is confident about one prediction. A cautious BOJ -- blamed by politicians for raising rates too quickly in the past -- will likely move very slowly, giving the market ample time to adjust.

"What's most likely to happen is that it will be a relatively smooth process," he said.


Jin Saito, Japanese analyst at Washington-based financial advisory The G7 Group, said a gradual adjustment is all the more probable because Japan is just one source behind the currently high global liquidity levels which have kept U.S. long-term rates low and demand for high-yield and emerging-market assets strong.

Moreover, Mr. Saito said that with the government having a massive debt to service, there could be "intense" opposition from the powerful Ministry of Finance to a tightening cycle that pushed short-term rates above 1% -- lifting longer-term rates and raising borrowing costs.

Treasury Trading

Treasury prices settled near unchanged levels Friday, reversing earlier gains briefly accrued after a surprise fall in durable goods orders. In market activity Friday, the benchmark 10-year Treasury note declined 4/32 point, or $1.25 per $1,000 face value, to 99 13/32 points, while its yield rose to 4.577% from 4.561% Thursday.

Corporate Bonds

Dana Corp. bonds fell sharply again after a Wall Street Journal article said the auto-parts supplier has hired restructuring advisers.

The losses extend a selloff that began in earnest Thursday, as market participants questioned whether the company would be able to successfully renegotiate its crucial lines of bank financing -- essential to Dana's long-term viability. The company's troubles intensified when two major ratings companies cut Dana's credit rating multiple notches Friday afternoon -- to nearly the bottom of the ratings scale. Dana's 6.5% notes due 2008 sank more than nine points to 64 cents on the dollar, according to MarketAxess. Its 6.5% notes due 2009 fell more than four points to 63 cents on the dollar.