Japan's Fuzzy Math and European Scare Tactics

By: Gary Dorsch | Tue, Aug 29, 2006
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"If Liars can figure, then figures can lie." How should one react to Tokyo's fuzzy math, after government apparatchniks added 34 items to the Japanese consumer price index, whose prices on balance were falling, and removed 48 goods and services that were becoming more expensive? The fuzzy math produced a stunning two-thirds decline in Japan's core consumer inflation rate to 0.2% in July, from the 0.6% inflation rate reported in June, jolting Japanese interest rates.

Year-on-Year % chg








Core CPI Old Base








Core CPI New Base








Tokyo's new methodology for computing the core rate of consumer inflation, included revisions for all the 2006 data, and the difference is dramatic. In the month of May for instance, the new core CPI base showed zero inflation, compared with a 0.6% annualized rate under the previous rules. If correct, the Bank of Japan made a mistake in dismantling quantitative easing in March and in raising rates in July.

In an age when governments of every political stripe distort data to promote their self interests, it's hardly surprising that the new formula for computing inflation suits the interests of Japan's LDP party. By the same token, it is entirely natural for official inflation data to be wildly at odds with the reality faced by business and consumers, and is often regarded with cynicism and disbelief.

Behind Tokyo's sleight of hand, is a power play between the Japan's ministry of finance, which aims to block Bank of Japan chief Toshihiko Fukui, from tightening monetary conditions. Already, Fukui has drained 22.7 trillion yen ($200 billion) from the banking system since March 9th, after dismantling a five year ultra-easy policy that pegged the overnight loan rate at zero percent.

The MoF is also trying to drive Japanese government bond (JGB) yields lower to cushion the local economy, which slowed to an annualized 0.8% in the April-June quarter. That compared with a 2.7% expansion in the first quarter, the sixth straight quarter of expansion. The slowdown in Japan matches the trend in the United States, where GDP growth slowed to 2.5% in Q'2 from 5.6% growth in Q'1.

The consequences of Tokyo's latest maneuver are crystal clear. Japanese chief Cabinet Secretary Shinzo Abe commented after the release of the rigged CPI figures, "We need to make our economic recovery sustainable. We would like the BOJ to support the economy on the monetary policy front," he said. Thus, the ruling LDP party has stolen the thunder from the BOJ, and is trying to clamp the hand-cuffs on the central bank for the remainder of 2006, and maybe into Q1 in 2007.

The rigging of Japan's CPI data damages Tokyo's credibility, and breeds suspicion over the reliability of Japanese economic data. Traders can only trust the hard dollars and cents that flow through the global commodity markets for real-time indications of inflation, and not government statistics. Perhaps, Tokyo bond traders anticipated the sharp decline of the Reuters Commodity Index (CRB), which fell below a key upward sloping trend-line on August 28th, easing global inflation pressures.

Is the Bank of Japan handcuffed for the rest of 2006?

Prior to the new formula for measuring Japanese inflation, BoJ chief Toshihiko Fukui was skillfully laying the groundwork for a quarter-point rate hike to 0.50% in the fourth quarter. "We will support the economy so as not to spur inflationary risks. We have the difficult policy objective of keeping financial conditions loose as much as possible to the extent that we do not bring about such risks. We are not in a rush to adjust rates, but we cannot be too slow either," he said on August 18th.

However, recognizing the MoF's pre-emptive power-play over the BOJ's monetary policy by rigging the CPI figures, Japanese yen Libor futures soared 14 ticks to the 99.49-level in Singapore, lowering the implied yield to 0.51%, and ruling out a BOJ rate hike this year. The US dollar climbed to as high as 117.30-yen, the upper end of its summer trading range, along with the rally in yen Libor futures.

Tokyo in pursuit of cheap yen policy

The ministry of finance (MoF) favors a weak yen policy to boost the earnings of Japanese exporters and multinationals, which in turn, inflates the market value of shares on the Tokyo Stock Exchange. For example, Toyota's annual operating profit increases 35 billion yen for each 1-yen rise in the value of the US dollar against the Japanese currency. The MoF is satisfied with the US dollar gyrating between 114-yen and 117.50-yen, and is achieving great results within this range.

Japanese exports to the US jumped 15.9% in the first half of 2006, to a record 8.1 trillion yen, and the trade surplus expanded 17.4% to 4.2 trillion yen, marking the highest level since the latter half of 1986. Exports to China, excluding Hong Kong, expanded 26.1% to a record 4.96 trillion yen, also a record high. Japanese exports to China have tripled from four years ago, and are on pace to exceed sales to the US market over the next six years.

By putting a major stumbling block in the way of further BOJ tightening, with a series of rigged CPI numbers, the MoF has placed a floor under the US dollar at 114-yen, despite indications the US federal funds rate might have peaked at 5.25%. From a technical perspective, a key downward sloping trend-line of resistance is currently residing at the 117-50-yen, and Nikkei-225 traders are very interested to see how the US dollar performs at this level.

The MoF can influence the dollar /yen with verbal jawboning, outright intervention in the currency market, or pressuring the BOJ for a cheap money policy. The BOJ still buys 1.2 trillion yen ($10.2 billion) of government bonds every month from financial institutions and the MoF purchases 150 billion from local investors each month to keep interest rates artificially low. Together, the BOJ and MoF are monetizing half of Japan's 30 trillion budget deficit in 2006, at the lowest bond yields in the world.

But with Japan's trade surplus with the US at a 20-year high in the first half of 2006, the unwinding of the structural US trade imbalance would require a weaker US dollar. But the greenback is propped up by a 5% interest rate advantage over yen Libor rates, up from a 1.2% rate advantage in Q'1 of 2004. However, if signs of a hard landing for the US housing sector begin to emerge, the Fed could start lowering the fed funds rate and weaken the dollar, thus unraveling Tokyo's scheme.

Tokyo Jawbones JBG yields lower

Tokyo's mastery over the Japanese government bond (JGB) markets is iron clad, with few Japanese bankers willing to disobey the dictates of the ministry of finance. MoF chief Sadakazu Tanigaki put a lid on benchmark JGB 10-year yields at the psychological 2% level on July 12th, when he warned, "deflation in Japan is not over yet, there's no need to rush BOJ rate increases, as inflationary concerns have yet to emerge. The BOJ needs to watch markets and the underlying economic conditions, before deciding on rate moves," he said.

The core CPI revisions on August 25th, left Japanese traders scrambling to buy JGB at marked-up prices, although past investment decisions were made with faulty and unreliable inflation data. Foreigners abandoned the low yielding JBG market many years ago, with only 5% of Japan's 774 trillion yen ($6.7 trillion) of public debt, owned by investors from abroad. Instead, Japanese banks own a colossal 140.4 trillion yen ($1.2 trillion) of JGB's, roughly the size of Canada's economy.

Although foreigners are not active in JGB's, the Tokyo bond market has significant influence over other bond markets. German 10-year Bund yields fell by 32 basis points since July 4th, when Japanese 10-year yields peaked at 2.00%, before falling 32 basis points to 1.68% on August 28th. German bund yields are sliding, despite expectations of at least one or two more ECB rate hikes by year's end. Tokyo is having a greater influence over the direction of German bunds than the ECB.

But while Japanese bond traders were easily duped by the revised CPI figures, Tokyo gold traders scoffed at the fuzzy math. After the dismantling of "quantitative easing", Japanese bond yields and the gold /yen price were moving in lockstep, reflecting a joint monitoring of inflation. But while 10-year JGB yields plunged to 5-month lows on August 28th, Tokyo gold prices remained defiant, and steadied near 72,000 yen per ounce, or 8.5% below their 18-year highs.

With the BOJ pumping 1.2 trillion into JGB's each month, and thinking twice about draining yen through open market operations, a renewed build-up of yen supply could keep gold prices buoyant. If Tokyo gold prices remain stubbornly high, the recent decline in the Japanese 10-year bond yield could be short-lived. In order to knock the stuffing out of the gold market towards 65,000-yen /oz, the Japanese MoF is banking on heavy European gold sales in the weeks ahead.

European Scare Tactics in Gold Market

Europe's central banks have sold about 340 tons of gold for the fiscal year ending September 26th, below their annual quota of 500 tons, with only four weeks remaining until time runs out this year. The fear of sudden European dumping of gold has put a lid on prices, since peaking at $675 /oz on July 17th. France has sold 116.5 tons thru the end of June, higher than the 115 tons sold last year, and still owns 2,790 tons of gold. Spain has sold 35.6 tons, up from 30 tons last year.

In an interview with German daily Bild on August 22nd, Bundesbank chief Axel Weber was ambiguous, "It's conceivable that our reserves could be reallocated somewhat, from gold into foreign currencies. But we don't want to draw on Germany's currency reserves." Germany's gold reserves are the second largest in the world, worth 54 billion euros ($69.6 billion) at the end of July. The Bundesbank also holds foreign currency reserves, including US dollars and yen that are worth 28 billion euros.

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Gary Dorsch

Author: Gary Dorsch

Gary Dorsch

Gary Dorsch

Mr Dorsch worked on the trading floor of the Chicago Mercantile Exchange for nine years as the chief Financial Futures Analyst for three clearing firms, Oppenheimer Rouse Futures Inc, GH Miller and Company, and a commodity fund at the LNS Financial Group.

As a transactional broker for Charles Schwab's Global Investment Services department, Mr Dorsch handled thousands of customer trades in 45 stock exchanges around the world, including Australia, Canada, Japan, Hong Kong, the Euro zone, London, Toronto, South Africa, Mexico, and New Zealand, and Canadian oil trusts, ADR's and Exchange Traded Funds.

He wrote a weekly newsletter from 2000 thru September 2005 called, "Foreign Currency Trends" for Charles Schwab's Global Investment department, featuring inter-market technical analysis, to understand the dynamic inter-relationships between the foreign exchange, global bond and stock markets, and key industrial commodities.

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