What Do They Know That We Don’t?

A strange thing happened two weeks ago.

Japanese investors bought a record $16.8 billion in U.S. bonds in the week of August 2nd to August 6th, 2004 — a new one- week record.

Now, what do the Japanese know that we don’t?

Last time I checked my securities books, when interest rates rise, bond prices fall. It was widely expected that the Fed was going to raise rates on August 10th. And the expectation was well built into U.S. bond prices. It was only the second time in four years that the Fed raised rates.

So why the devil would Japanese investors buy a record amount of our bonds, when the Fed has repeatedly announced it would continue to raise interest rates in “measured moves?” Last Tuesday, the Fed even said that, despite high oil prices, the “economy nevertheless appears poised to resume a stronger pace of expansion going forward.” Translation — more interest rate hikes ahead.

My guess is that the Japanese are remembering August 2000. That’s when the Bank of Japan raised its domestic interest rates for the first time in several years. We all know what happened after that. Less than six months after it raised rates, the Bank of Japan was forced to reverse its actions and lower rates below what they were before they were increased!

The yield on the Japanese government 10-year bond rose from 1.69% to 1.99%, when the Bank of Japan raised rates in August 2000. Six months later, very poor economic conditions in Japan forced the Bank to lower rates aggressively, with the yield on the popular 10-year bond actually falling to 1.02%. It even fell as low as 0.43% last year. Today, it sits around 1.5%.

Looking at this experience, my guess is that the Japanese see the weak U.S. job numbers, weak retail sales number, and weak growth numbers that were released prior to the U.S. Federal Reserve’s rate increase as reminiscent to the Bank of Japan’s ill-fated rate increase of August 2000.

The Japanese are basically betting that the Fed will have to lower rates again down the road, spurring the price of U.S. bonds. They see the U.S. Federal Reserve following the ill- fated steps the Bank of Japan took. Unfortunately, I think they could be right.