Friday, July 14, 2006

Money for Nothin'... Spread for Free

Today marks the end of an era for many hedge funds and speculative players in the bond market. The Bank of Japan has ended its Zero Interest Rate Policy (tm), affectionately called the ZIRP by those who profited greatly from it. For the last six years, the BoJ has kept their target interest rate at zero in a desperate attempt to revive their moribund economy. Now with private banks finally willing to lend and citizens finally willing to spend, at least a little, the BoJ must begin the tricky task of normalizing interest rates.

Removing the ZIRP without plunging their economy back into deflation will be like trying to defuse a bomb while wearing mittens and a blindfold. The Japanese economy has been either in bubble or bust mode for the last 30 years, and no one deserves more blame than their central bank. In the 80's, when it looked like the Japanese way of doing business would one day take over the world, the BoJ was too cozy with private bankers to take on the problem of a real estate bubble. By the time they acted, the bubble had gone too far for the air to be let out slowly. The bust caused both a bank crisis and generalized deflation.

Yet again, the BoJ was slow to act. By 1992, CPI had already fallen from 4% to 2% in less than 18 months. They did cut rates slowly between 1991 and 1995, but CPI kept plummeting, falling below zero in 1995. Many American economists, including Ben Bernanke, wondered aloud why Japan didn't simply print money to cause inflation. Their central bank had lost all credibility to control prices, and therefore even an overnight rate of zero took many years to have an impact. Even now, 4 out of the last 12 monthly Japanese CPI prints have been negative, so to say that they are safely out of the deflation woods is extremely premature.

If the populace smells deflation again, they will go back to their old over savings ways. Deflation creates an incentive to just hold on to money because falling prices makes cash more valuable. Over savings fuels deflation, because businesses feel compelled to cut prices to move product. If the BoJ hikes too fast deflation will return. If they continue with the ZIRP, there is a serious risk that a new asset bubble will form, destabilizing the economy again.

Meanwhile, traders around the world have benefited greatly by borrowing cheaply in the Japanese markets and investing in risky assets to capture the spread. I believe this has been a major driver in the sell off in emerging markets stocks and bonds over the last 2 months. To a lesser extent, this may be fueling the move in corporate spreads over the same period. The market now sees Japanese short-term rates moving into the 1-2% range over the next 12-18 months, and this move will squeeze many risk traders. Many have talked about the exponential growth of hedge fund assets over the last 3-5 years, and some have feared another Long-Term Capital Management-type catastrophe. If such an event occurs, you'll be able to trace it back to the ZIRP.

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