Why I Wake Up and Google Japanese Bonds Every Morning

As an outward proponent of monetary expansion from central banks around the world, my eyes have been fixed on Japan.  I have pretty strong views on monetary policy, but I'm not sure I'm right.  At least, I want to be open to the idea that there are plenty of people smarter than me that disagree with me.  Well, last Thursday the Bank of Japan set out to do what new Prime Minister Shinzo Abe had been promising.  Raise the rate of inflation in Japan to 2% from zero.

This was promised in the campaign, but there were plenty of people that didn't think he was serious.  And the truth is we are still learning how committed they are.  They are committed to raising the inflation rate "to 2% within two years."

I talked my class through some basic monetary theory earlier in the year, and since none of them had been watching Japan.  I got them to walk me through what we talked about.

What should happen to stocks if the central banks commit to printing money, buying bonds and raising inflation?

They said, go up pretty quickly, which is pretty clear.  Even if you don't think it will raise growth, the inflation rate alone should make stocks rise.  [If growth is expected, future dividends will be higher and future discount rates lower, which will both increase stock prices.]

What should happen to the yen against other currencies?

They got that pretty fast.  It should be devalued.  It will weaken.  

What should happen to bonds?

Silence...  I said, this is good, because we gave too stories for the effect of the central bank on interest rates.  I talked them through the easier one.  The central bank has decided to buy a bunch of bonds, what should happen to bond prices?  "They should go up..."  If the price of a bond, goes up, what happens to the yield?  (this relationship is still tough for first year students, but some have it down)  "The yields are down..."  Good that's one story.  

Now the other story.  Remember what we said the components of an interest rate were, the real rate and the inflation premium.  What did I just tell you the BOJ had promised to do to inflation?  "Raise the inflation rate..."  So what has to happen to the required interest rate, which is also the yield?  "It goes up..."  But if the yield goes up, it means the price goes down. The BOJ can buy so many bonds, bond prices go down... At some level I always new this was true (or I used models in which it was true), but a series of Scott Sumner posts and the experience of teaching an intro finance course made me realize how nuts it is (in a good way).  Something both true and not obvious.

So I asked my class, we told two stories, what do you think has happened to Japanese bonds?  ....(Silence)   They've gone nuts!  Volatility has been insane and the futures market has been shut down twice due to volatility linked circuit breakers.  Though, on announcement they were down.  I also said, if the BOJ succeeds in raising the inflation rate, I think yields have to rise and the second story holds.

So every morning, I wake up and check Bloomberg or the BOJ website for  yields on Japanese bonds.  The day before the BOJ announcement, the yields were .56%.  The day of the announcement they fell to .44%.  The next day, yields rose to .53% the day after announcement (remember the BOJ was still buying a bunch of bonds and yet prices started falling!).  Today, they are at .58% and above the day before announcement.  

Let's say the real interest rate in Japan is 0%.  Then even if the real rate doesn't budge, if the BOJ is serious and can create inflation over time the 10 year should rise to 2%.  Now, its plausible the real rate is even negative.  The U.S. Inflation Adjusted bond yields -.6%, which would mean a rise to 1.4%.

Further, if I'm right and the BOJ does hit their target, employment should rise, the economy should grow and the real rate should rise (eventually)...  But I also respect that markets are pretty efficient, so there is some chance that the BOJ caves and contracts prematurely as they have in the past.

But for quite awhile, I will likely wake up and look for news about Japan...