This article is from the Australian Property Journal archive
In chaos theory it’s called the butterfly effect – when a seemingly insignificant event in one part of the world has a larger impact in another part – the flap of a butterfly’s wings in Brazil setting off a tornado in Texas, for example. It is hard to believe but the fact that consumer prices are now rising in Japan may be the flap that shakes the very foundations of global financial markets.
As was widely expected, the Bank of Japan took the first steps last week towards tightening the liquidity spigots that have been keeping the Japanese economy afloat for the past five years. Behind the decision was evidence that the economy is slowly but surely pulling itself out of a quagmire of deflation-induced stagnation. The economy racked up 4.5% growth in the final quarter of 2005, far outstripping growth in the US, and prices are once again rising for the first time in seven years.
The flutter of recent events in Japan has not been lost on bond markets. Since the middle of January, the yield on the 10-year US Treasury bond has risen from 4.32% to 4.72%. It is now at its highest level in close to two years. The bounce in the US market has, in term, been felt in other markets. Over the same period, Australian 10-year yields are up 27 basis points to 5.38%.
Of concern to bond investors is a sense that the balance of global growth is starting to shift – away from the debt-laden, asset-inflated, import-addicted US consumer, toward Japan and possibly even Europe. This may very well be the case. Japan has not looked this good in a decade while activity indicators are beginning to point north in Europe.
Whether this sense of rebalancing is real or imagined doesn’t really matter. In the current environment, fiction can quickly become fact. All it takes is for enough bond investors to believe such a rebalancing is under way for money to flee US Treasuries, driving bond yields higher in the process. This in turn puts pressure on US housing investors, whose financial fortunes are tied to the long-end of the yield curve, casting a shadow over the whole economy in the process.
US households are heavily indebted. In contrast to the corporate sector, where debt to net worth ratios are at 32-year lows, in the household sector they are at record highs. Much of this debt is tied to long-term bond yields. If bond yields continue to rise, the cost of buying a house also rises. The US housing market is already beginning to show signs of strain. According to the January Foreclosure Market Report, 103,540 properties nationwide entered some stage of foreclosure in January. That is up 45% from the same time last year.
How badly the US economy is destined to ail as a result largely depends on how much further bond yields will rise. The concern is, that with risk so poorly priced, and investors so heavily leveraged, the flexibility of the financial system to withstand any financial shock is significantly reduced.
Investors take note – the flap of the butterfly’s wings in Japan may not be enough to cause a tornado in global financial markets, but it is enough to signal the end of free and easy liquidity conditions. For the first time in 17 years, all three major central banks are tightening at the same time.
On the one hand, this is good news because it signals the global economic patient is ready to return to more normal duties. On the other, it means risk and volatility will return. We will likely see weaker growth in the US, higher global bond yields, and a weaker US dollar. Australia too will feel the flutter in this new environment. In a more balanced world, the number of attractive places to invest increases, meaning competing for world funds to sponsor our current account deficit may get a little harder.
Tracey McNaughton, senior economist with BT Financial Group.*
