Stock Market Smarts: Japan Goes Negative

Move signals more aggressive approach by central banks and potentially more profits for bonds.

A few evenings ago I had dinner with an American economist. Naturally, the discussion quickly turned to investing and the rocky start for stocks in 2016. We spent some time analysing why equities had plunged so far so fast when the underlying fundamentals hadn’t changed dramatically.

Our conclusion was that the correction was sparked by four factors: an overpriced market, the Fed’s decision to raise its key interest rate, the continuing rout in oil prices and investor nervousness over China.

The market still looks overpriced today, although clearly not as much so as at the start of the year. The Fed seems to be backing away from the idea of another rate hike soon. Oil prices firmed last week amid reports that OPEC and Russia were considering production cuts. China still remains a huge question mark, but overall we agreed that the tone of the stock markets should be somewhat better in February.

The Bank of Japan shocked just about everyone on Friday by announcing that it will now charge 0.1 per cent on excess deposits and warned it may cut rates further if required. Predictably, the yen fell in value, good news for Japanese exporters and bad news for North American carmakers. Bond markets around the world rallied sharply as yields fell.

Some people are puzzled by the inverse relationship between bond prices and yields. Look at it this way. A government issues a 10-year bond with a 2 per cent coupon. So for every $1,000 face value, an investor receives $20 a year in interest. Then rates drop to the point where new 10-year bonds are only paying 1.5 per cent, or $15 per $1,000 invested. The old bond, with its $20 annual payment, is now worth about $1,333, the price at which it would generate the same yield as the new issue. (This is a simplified illustration; the actual price would depend on several factors including time left to maturity.)

Now imagine what would happen if interest rates went negative. The price of that 2 per cent bond would soar because it would be paying a positive return while new issues were charging investors for the privilege of holding them.

That’s exactly what has occurred in some parts of the world and there is no reason it can’t happen here as well if economic conditions don’t improve. The move by the Bank of Japan was unthinkable, until it wasn’t.

Why are we seeing this unusual phenomenon? Essentially because global growth is weak, deflation is a greater threat than inflation in many developed countries, and central banks increasingly feel a need to take dramatic action. Negative interest rates qualify.

The effect has been to propel bond prices higher this year, in contrast to the gloom in the stock markets. As of the close on Jan. 28, the Morningstar U.S. Core Bond Total Return Index was ahead 1.13 per cent year-to-date. Treasuries were even stronger with the U.S. Government Total Return Bond Index up by 1.78 per cent.

The gains in Canada weren’t as dramatic but bonds were still on the plus side with the FTSE TMX Federal Bond Index ahead by 0.79 per cent for 2016.