Japan has been experiencing highly volatile yields these past couple of months. With the problems of deflation and continuous periods of contraction plaguing the Japanese economy, the Bank of Japan has had to resort to continuing its easy-money policy.
Easy-money is the same monetary policy that the Federal Reserve enacted to spark U.S. growth and bring the U.S. economic out of a recession following the 2008 financial crisis. When the Bank of Japan carries out this policy, it purchases government bonds from Japanese banks. By doing this, it floods the economy with money, meaning it is increasing the money supply. Increasing the money supply will have an inflationary effect.
With a surplus, money becomes easier to obtain, driving interest rates and with Japanese bond yields down. As a consequence, the cost of borrowing for Japanese firms will decrease and firms will issue more debt; this debt is in the form of corporate bonds. Firms will then have the funds to invest in projects or buy back stock. This will increase a firm’s future income and increase the value of its equity. If one were to look at the Japanese Nikkei for the past year, one would see a fairly large stock market rally, roughly a 24 percent increase.
With a rally like this, investors will be more attracted to the massive returns in the stock market versus low-yielding bonds. Japanese yields have increased in response to this attraction, doubling from .195 percent to .41 percent in just a month. This happened because yields rise as prices fall; they are inversely related. Prices fall because there is a decrease in demand, as demand is a major driver in bond prices. Without demand, prices were destined to fall. But when the yields rise as a consequence in the future, investors will be attracted to short-term bonds once again. This will create a vicious cycle, one with incredible volatility.
Although there are concerns about this volatility, Japan has been showing signs of recovery. It is difficult to determine when the Bank of Japan will be able to end its bond-buying program, but there is no doubt that it is working.
Feb. 27, 2015