Japan Between A Rock And A Hard Spot Part - III

The following analysis are not the original thoughts of this writer - credit must go to Randall W. Forsyth, who in early 1996 first discovered the uncanny relationship between foreign Central Banks increased holdings of U.S. Treasuries and the unprecedently long bull market in Wall Street stocks. Forsyth's initial recognition of the correlation was published early last year in Barron's. Subsequently, Economist George S. Cole mentioned the relevance of the two factors in several of his Internet postings earlier this year. The contribution of this writer was to expand upon the original thoughts of Forsyth and Cole.

The Prime Motive Force Moving the Stock Market -

It is no great revelation to observe that the U.S. stock market is currently enjoying the longest, uninterrupted and exaggerated bull trend in its more than 200 year history. The excesses far exceed the market mania of the fabulously speculative seven years between 1922 and 1929.

Many analysts have postulated as to the reasons or causes for the current irrational exuberance. Some fault Wall Street hype. Some say it is the seemingly inexhaustible flow of funds from 401-K plans. Some blame the naive public which believes stocks can continue returning 15-20% annually from now to the hereafter. Some claim it is the ingenious work of the politicians, who have permanently killed inflation by keeping a downward pressure on interest rates through Fed intervention. (Whereas a low interest environment certainly is conducive to rising equity prices, one must ask what generated the conditions for declining rates?) Too, there was Forsyth's hypothesis - which contends the constant flow of foreign funds into U.S. Treasuries is the real impetus driving Wall Street prices.

This writer has examined and studied all the above possible causes of Wall Street's relentless rise. Certainly, they all contribute in some small degree to the current market madness. However, very little supporting numbers could be found to suggest these factors are the prime motive force that provides any material influence - EXCEPT ONE: the constant and accelerating flow of foreign funds into Treasuries. This deluge of funds is far bigger - albeit less visible - than all the other factors COMBINED. It is the global flow of funds funneled to Wall Street via the U.S. Treasury market. The term used by the Fed in referring to this capital flow is the number of "US Securities Held In Custody at the New York Fed for Foreign Central Banks and International Monetary Authorities."

Although foreign ownership of Treasuries has been growing rapidly for the last 20 years, recent years growth by comparison has been exponential. From early-1995 to March 1996, the holdings increased 31% to $519 billion. Moreover, during the last 12 months foreign holdings spurted another 26% to its $653 billion peak in mid-April this year. Interestingly, the Fed's own holdings of U.S. Treasuries totaled a mere $400 billion.

In light or recent international developments (Japanese Prime Minister's premeditated warning to the U.S. government, among others), it is relevant to observe FOREIGN HOLDINGS HAVE BEGUN TO DECLINE IN THE LAST COUPLE OF MONTHS TO $632 BILLION - indicative of waning foreign interest in U.S. debt paper.

Reality Check -

Last month Prime Minister Ryutaro Hashimoto's said the Bank of Japan (BOJ) would dump T-Bonds and buy gold, if the American government continued to allow the greenback to decline, and if the Fed failed to hike interest rates. In a vain attempt to down-play Hashimoto's declaration, Secretary Rubin commented the BOJ only had about $200 billion invested in Treasuries. This writer questions this estimate. Firstly, the press reported in mid-1996 that the BOJ had already accumulated $220 billion. It is also believed that the BOJ continued to increase its T-Bond exposure until just recently. Therefore, the BOJ may just well be the holder of considerably more than $200 billion. Furthermore, one must add to the BOJ figure a portion of the approximately $800 billion in U.S. investments owned by the Japanese private sector (banks, savings & loans, credit-unions, insurance companies and pension plans). We are talking ONE TRILLION DOLLARS IN U.S. INVESTMENTS. Therefore, it may be reasonably concluded the Land of the Rising Sun probably holds more U.S. Treasuries than the Fed itself.

Why Is this Significant?

The above data are significant for a number of salient reasons.

Firstly, the Japanese economy is plagued with several serious problems. It is still suffering the effects of its horrendous stock market crash, which began the first trading day of 1990 (and is currently still down 49% from its 39,000 Nikkei peak). More grievous for the economy is the increased value of the Yen in recent years - which has made its export industries far less competitive. Furthermore, the Japanese financial world has been racked by a chain of scandals: Daiwa Bank trader causing $1 billion in losses, Sumitomo Corp. Copper rogue-trader causing $3 billion in losses over a 10-year period, alleged Nomura Securities relationship with a underworld gangster, and most recently the very irregular operations at Dai-Ichi Kangyo Bank - where 10 current and former senior executives are under arrest for suspected involvement in illegal payoffs to sokaiya racketeers. Consequently, many individual savers are pulling their deposits and deserting Dai-Ichi Bank. On top of this barrel of financial worms, there is the festering problem of massive bad-loans. It is reported the Japanese banking system is hamstrung with $400-$600 billion in unperforming loans. One of these days the BOJ will have to bite the bullet, and be forced to swallow these bad-loans.

Secondly, the BOJ is not fulfilling its fiduciary responsibility of a Central Bank in diversifying its asset base. As mentioned in Part - II of this series, Japan is awash in dollars. Media sources suggest the preponderance of the BOJ's total assets is U.S. Dollar denominated. Whereas the BOJ has some international foreign currencies, it has practically NO GOLD - considered by many as the most universally accepted currency. Per the BOJ's June 27, 1997 Balance Sheet (below), gold represents a scant 0.37% OF ONE PERCENT OF THE CENTRAL BANK's TOTAL ASSETS. In sharp contrast the U.S. FRB has 262 MILLION OUNCES OF THE YELLOW METAL. FRB gold is carried on the books at only $42.22. If it were valued at current prices of about $325 per ounce, the FRB's gold reserves would account for about 14% of its total assets. Unfortunately, the writer does not know the per ounce value of gold assigned to the BOJ's Balance Sheet. However, the absolute value is readily apparent.

(thousands yen)

Thirdly, subsequent to Prime Minister Hashimoto's "T-Bomb" dropping at Columbia University last month, the international press announced Japan's accumulation of Treasuries has diminished dramatically. Specifically, Japan's heretofore insatiable demand for T-Bonds was rising at an annual rate of 30% (1996). However, during the last couple of months there has been a draconian decrease in demand to only 6% - a tell-tale indicator of the Nippon's change in financial appetite.

If we are to believe that Prime Minister Hashimoto is a politician not prone to cavalier remarks in public, and does not lean toward childish bluffs regarding the welfare of his country, then we are forced to be of the opinion HE WILL NOT RISK LOSING POLITICAL-FACE BY BACKING AWAY FROM HIS VEILED THREAT TO SELL T-BONDS AND BUY GOLD, if the U.S. shies away from defending the greenback, and fails to increase interest rates. Relevant is the FOMC's recent decision to stand pat on rates, even while the dollar continues to slip. Looks like the ball is in Hashimoto's court.

Wall Street Owes Thanks to the BOJ -

There are many factors which have contributed in a small degree to the longevity of the current bull market in U.S. stocks. Nevertheless, it is the hypothesis of Randall W. Forsyth that the relentless flow of foreign funds into the U.S. Treasury market has indeed been the prime motive force blowing Wall Street's bubble.

Consequently, when the Nippons reverse gears and begin to divest themselves of U.S. debt paper, the bubble will burst, rates will soar, and the dollar will plummet - and gold should rise dramatically.

Indubitably, there are skeptics who may try to deny the significant correlation of Central Bank Holdings of U.S. Treasuries to the irrationally exuberant rise in the stock market - as reflected by the S&P 500 Index. However, even the most staunch "Doubting Thomases" should be convinced otherwise by the chart below depicting the correlation of Foreign U.S. Treasury Holdings growth to the exponential rise of the S&P 500 during the last 20 years (1978 through June 1997). Please take careful note there is a 97% correlation between the two curves. Even the most incredulous must dismiss the possibility of coincidence.

Conclusions -

1. The inexorable flow of foreign funds into U.S. Treasuries has fostered and sustained greatest and longest bull market in Wall Street history. It has and continues to be a binge of unbridled speculation - indeed a market running amok. U.S. Stocks have zoomed to untenable market valuations... not too dissimilar to the terminal Nikkei in the last quarter of 1989, just before it plummeted 64% during the next two and a half years. Although off its nadir, the Nikkei continues to languish - down 48% from its all-time level of Irrational Exuberance in January 1990.
2. The gusher of liquidity from abroad has helped prevent the dollar from tumbling even more.
3. Insatiable foreign demand for T-Bonds has kept downward pressure on interest rates. Without this demand, long-term rates might well be between 7.5% and 8.5%.
4. Continued downward pressure on rates has created an environment allowing stock valuations to attain unprecedented and unwarranted levels of speculation: Dividend yields less than 2%, P.E.R greater than 22, and Market to Book Ratio of 5:1. All far in excess of the market madness preceding the Great Crash of 1929.
5. Recently, there is a notable de-acceleration of Japanese T-Bond accumulation: from 30% in 1996 to only 6% this year. And massive divesture looms on the horizon.
6. Japan's Prime Minister Hashimoto publicly stated the BOJ's future investment strategy in the event the Fed failed to stabilize the Dollar/Yen parity. Rates stand pat, and the dollar continues to dribble. To save political-face, Hashimoto has no alternative if he plans to remain in office.
7. This writer foresees the inevitable: The BOJ will begin to dump U.S. Treasuries - prompting other foreign central banks to follow suit. Consequently, U.S. interest rates will begin to soar - putting downward pressure on U.S. stock prices. Much of the excess liquidity will seek safety in hard assets.
8. The chart comparing Foreign Holdings of Treasuries and the S&P 500 Index demonstrates a 97% correlation over the last 20 years ON THE UPSIDE... Therefore, in this writer's mind there is little logical doubt the relationship will indeed continue ON THE DOWNSIDE... finally bursting Wall Street's Bubble.