The significance of the BoJ’s yield-cap increase … what could it mean for global risk asset prices? … our technical experts’ take on a “Santa Claus Rally” … their short-term forecast

One of the biggest headlines of the week came from a shocking move by the Bank of Japan (BoJ).

As we covered here in the Digest, the BoJ made a big, surprise move on Tuesday by increasing the cap on its 10-year bond yield from 0.25% to 0.50%.

This was basically a de facto interest rate hike because it amounts to monetary tightening. Raising bond yields increases the cost of capital.

Now, what’s shocking is that Japan has been the world’s last central bank holdout when it comes to tighter monetary policy. In fact, the BoJ has been in “accommodative” mode for – literally – decades. Specifically, since the 1990s in the wake of their historic stock market meltdown.

(In the 1980s, Japanese share prices surged 3X faster than corporate profits, resulting in the Nikkei trading at an eye-popping price-to-earnings ratio of 60 in 1989. When the bubble popped, Japanese equities fell 50% in a single year, ushering in the Lost Decade(s).)

So, the idea that the BoJ would suddenly change policy this week came as a huge surprise to the financial world.

For more, let’s jump to our technical experts, John Jagerson and Wade Hansen of Strategic Trader. From their Wednesday update:

The BOJ made the move to start normalizing monetary policy, but we don’t know what “normal” monetary policy is for the BOJ.

The Japanese central bank has been the most aggressive at lowering rates and keeping them low among developed economies since its own asset bubble collapse in 1991.

To put this in perspective, the BOJ has only hiked rates twice since 1990, in 2006 and 2007 right before the global financial crisis. Talk about bad timing.

…The BOJ’s “normal” monetary policy is to stimulate with low rates. So, the move this week was a huge surprise and caught economists and traders off guard. 

From a “U.S. stock investor” perspective, why should we care?

Because the Japanese yen has been a backdoor way for global investors to help prop up the U.S. stock market.

Back to John and Wade to spell this out:

Over the last several years, investors around the world have been borrowing yen at very low rates in order to buy higher-yielding assets like U.S. stocks.

When the yen is cheaper, borrowing is even easier, and this benefits those other assets.

But now that Japan is showing the first signs of tightening monetary policy, it’s instantly impacting the yen. In the wake of the BoJ’s announcement, the yen has surged roughly 4% against the dollar this week. That’s a big move for only a handful of days.

Back to John and Wade:

A strong yen is bad for U.S. stocks. The correlation between a stronger yen and falling stock prices isn’t perfect, so don’t panic about this week’s surprise yet.

However, the two assets move together closely enough that this is a trend we should monitor closely.

For example, the yen has been rising since the BoJ started propping it up on Oct. 21 and stocks have been unable to break trendline resistance over the same period – the S&P 500 failed again after two attempts to break resistance over the last two weeks.

Let’s flesh this out to make sure we’re all on the same page.

If the BoJ continues these “camouflage interest rate hikes” via their 10-year bond yield, it could have a material impact not just on U.S. stock prices, but bond prices too, which could further aggravate the impact on stock prices.

You see, Japanese investors haven’t received any meaningful income from their domestic 10-year bond for years. If that’s now changing and the Japanese bond market is on its way toward offering meaningful yield, there’s the potential for a giant swell of capital from Japanese investors as they bring their money back to Japan (they’ve had to invest in foreign markets to find any meaningful yield for decades). But this would require Japanese investors to sell their current bond holdings from other countries.

And what do we know about the relationship between bond prices and yields?

When prices fall, as they would do if loads of bonds suddenly flooded the market, then yields would rise.

As we’ve covered here in the Digest, rising bond yields are a significant headwind for stocks.

Now, it’s too early to say that this dynamic will play out. But as John and Wade suggested, this is something we’ll want to monitor closely in the coming months.

Meanwhile, make sure your kids aren’t reading this, but John and Wade say there is no such thing as a “Santa Claus Rally”

Let’s jump straight to our resident Scrooges:

…The Santa Claus rally is not a real thing; it’s just something that financial journalists talk about because it’s fun and attracts readers.

The Santa Claus rally is loosely defined as a likelihood for stock prices to rise the week before and/or the week after Christmas. However, a historical analysis of those weeks shows the market is as likely to rise then as any other two-week period during the year.

John and Wade believe the more appropriate issue is whether the S&P will find support as the year closes out.

From a technical perspective, we lost support at 3,900 last week after the Fed’s rate decision. All eyes are now on the 3,800 level. We fell through this yesterday. The question is whether we can recapture it and hold support.

If not, how low do John and Wade see the S&P falling?

Back to their update:

In our view the worst-case scenario is a drop back to the prior lows near 3,600 on the S&P 500. Positive surprises from FedEx Corp. (FDX) and Nike Inc. (NKE) this week have confirmed that consumer and business spending is still relatively strong.

While we don’t think the market will break out to new highs, these reports increase the chance that support will hold, and we won’t see prices at or below 3,600 for a while.

Even if we’re surprised and see above-expected market volatility next week, take it with a grain of salt

Unless a major headline story rocks the financial world, any outsized market moves we see in the coming days will happen on light volume, which means we shouldn’t read too much into them.

The few days before Christmas and the week between Christmas and New Years usually marks the lowest market activity of the year. Because of this, the handful of buyers or sellers who show can push around prices far more so than during regular-volume market conditions.

Louis Navellier made a note of this to his subscribers in yesterday’s Platinum Growth Club update:

I know most folks are heading out for the holiday, so I wanted to send you a quick note in case you’re wondering why the market is down so sharply [yesterday].

The fact is there is no liquidity [yesterday]. Many traders have fled because the winter storm is messing up their travel plans. And [two days ago], although the market rallied, trading was still very illiquid.

…I wouldn’t worry about any major market swings.

As we wrap up today, we’ll return to John and Wade for the final word:

It may be a while before a new bullish trend emerges but a bounce back up to trendline resistance in early January seems likely.

We’ll keep you up to speed here in the Digest.

Have a good evening,

Jeff Remsburg