U.S. Benefits from Slow Interest Rate Increases

Japan continues to show signs of sustained growth in its economy. The strong upward trend of the benchmark Nikkei 225 remains positive. The barometer of large-cap performance in Japan touched a multi-decade high of 18,300.40 in late February, prior to some selling, but the trend has been steadily higher since. The index is holding at a near 52-week high and is up 16% from its 52-week low.

As I have discussed in previous articles, investing in foreign markets is important and helps to diversify your portfolio. It also helps to reduce the currency risk of holding just U.S. assets.

The resurgence in the Nikkei 225 is a clear indication that Japan’s anemic economy is finally growing. The economy grew at its fastest rate in three years, with GDP growth of 1.2% in the 2006 Q4 and an annual rate of 4.8%. In the 1990s, annual GDP growth was in the one-percent range, versus four percent in the 1980s. Consumer spending remains strong and inflation is benign in the country, which are positive signs.

Japan remains the second-largest economy in the world, with an estimated 2006 GDP at $4.218 trillion, trailing only the United States.

But with the economic recovery, the Bank of Japan axed its super- easy zero-rate monetary policy that had been in place for five years. Interest rates are currently at a miniscule 0.5%, and the Bank of Japan has held rates in six straight meetings. The central bank does not want to derail the economic recovery and suggested the move to a tighter monetary system would be slow.

 Benchmark interest rates are expected to hold during an adjustment period, waiting to see if the economy continues to develop. The central bank clearly does not want to choke off any economic momentum in the system. The next meeting is in August.

The decision to not increase rates rapidly is also a good sign for U.S. assets. Currently, Japanese investors are borrowing at very low rates and investing in higher-yielding U.S. assets. But the fear is that higher Japanese rates could impact investment in U.S. assets, thereby, lessening the demand for U.S. assets. This could result in declining prices. The aftermath could be a rise in U.S. interest rates to try to attract investment in U.S. assets.