Japanese Stocks Are At Highs- Volatility Ahead

This article was originally published on Nadex.com.

Japan has battled its demographic demons for decades. The low birth rate and aging population in the Asian nation have been eating away at productivity like financial cancer.

In the aftermath of the 2008 global financial crisis, Japan slashed short-term interest rates alongside the United States and Europe. While Fed Funds rate in the U.S. fell to zero percent, in Europe and Japan rates of interest declined into the abyss of negative territory. The monetary policy strategy with a goal of stimulating the economy by inhibiting saving and encouraging borrowing and spending cost made nest eggs in Japan into a wasting asset. Depositors wound up paying banks and financial institutions storage to hold their money.

Therefore, rates were not only at the lowest level in history in Japan, but they also placed those with savings in a bind with the prospects of watching their bank balances decline each month even though they did not withdraw as much as one yen.

Low rates typically drive capital from bonds to stocks, and since 2009, the Japanese stock market has experienced significant appreciation. 

Source: Barchart

As the chart of the Nikkei 225 futures contract highlights, the equity index rose from a low of 6,950 in March 2009 to its most recent high at 24,515 in October 2018. Even after the recent downdraft in equity markets, the index is still 3.3 times the level it was trading at just under one decade ago. At the same time, the U.S. S&P 500 index rose from 666.79 to its most recent peak at 2940.91 in September. At the 2,775 level the index is still 4.2 times the 2009 low. The U.S. stock market has outperformed the Japanese equities over the past decade.

While both the U.S. and Japan faced the perils of the 2008 financial crisis, three years later while the U.S. was nursing its economic wounds and attempting to put its financial house back in order, tragedy struck Japan. On March 11, 2011, a powerful 9.1 magnitude earthquake off the Pacific Coast of Japan caused a tsunami of destruction that killed 16,000 people and resulted in over $360 billion in damage to the Asian nation.  At a time when Japan was recovering from a financial crisis, an even worse event weighed heavily on the economy.

In December 2015, the U.S. Federal Reserve began increasing the Fed Funds rate for the first time in years. Since then, the Fed acted eight times to increase the short-term rate to 2-2.25 percent. At the same time, the U.S. central bank has instituted a program to allow the legacy of quantitative easing to roll off their balance sheet. Therefore, rates in the United States have been rising on the short, medium, and long end of the yield curve. While Europe’s quantitative easing program will cease at the end of 2018, short-term rates remain at negative forty basis points. In Japan, rates are also negative as we head towards the end of 2018.

Eventually, rates will begin to rise in Japan. However, the legacy of the massive impact of the 2011 tragedy and low rates of productivity in the Japanese economy will make the shift from monetary accommodation to tightening a slow process. Meanwhile, the psychological impact of a shift toward a more hawkish approach to interest rates in Japan is likely to create lots of volatility in the Japanese stock market. Volatility is a trader’s paradise, but it also creates a nightmare for passive investors. After years of watching bank balances shrink because of negative interest rates, Japanese investors in the local stock market could exit investments creating a tsunami of selling when the domestic rate finally begin to rise. 

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