The US markets usually lead the world, not the other way around. One of my market timing rules is that "once US financial commentators start focusing on weak international markets to forecast weak US markets, the US market is starting to find a bottom." And these days, all we hear on CNBC in the mornings is how weak markets in Europe, the Middle East and Asia are foretelling a weak open in the US. So, by that rule, we should be close to a bottom.
That said, the Bank of Japan (BoJ) holds one of the keys to unlocking this market decline. The BoJ’s actions, and the subsequent actions of the Nikkie, are now very important to the health of the US market and need to be monitored closely. For several years, financial commentators have been talking about the "carry trade," in which sophisticated investors and hedge funds have been borrowing money in Japan at virtually 0% interest and investing the funds in foreign markets at substantially higher rates. This has lead to a liquidity driven rally across all asset classes in the world.
However, since April, the BOJ has been pursuing a much tighter monetary policy. The following analysis comes from Merrill Lynch’s Japan economist Jesper Koll:
Why did equities drop so sharply? Empirically, there appears to be only one conclusive data point that explains the violent asset price adjustment: the cut in Bank of Japan (BoJ) quantitative easing. Since early April, BoJ liquidity provisions have been cut by ¥20- 24tn, a cut of almost 5% of GDP.
With the BoJ no longer funding ¥20-24tn of private assets, Japan’s private financial system must supply the funding. The good news is it is capable and willing to do so, as indicated by the fact that bank credit and broader monetary aggregates are accelerating smartly.
The bad news is the private financial sector commands a price. Unlike the BoJ, it wants to be compensated for the risks it is taking. Short-term money markets have risen and are poised to rise further, in our view.
Koll points out that economic indicators have continued to show steady growth and bank reserves remain healthy. The only explanation for the sudden correction is the fact that the "the BoJ cut the supply of free reserves from the relatively stable ¥30-35tn range maintained over the past two years to the current ¥10-11tn." Essentially, what this means, is that the BoJ has drawn money out of the financial system at a very rapid pace. That has caused interest rates to rise in Japan, which in turn has caused the "carry trade" to become unwound.
The BoJ’s liquidity withdrawal…
Source: Merrill Lynch
…has lead to higher interest rates…
Source: Merrill Lynch
…and lower stock prices.
Source: Stockcharts.com
Until the BoJ stops withdrawing liquidity and the trend in the Nikkie and Japanese interest rates reverses, it will be difficult for even the US markets to find a sustainable bottom.