Why Japan Surprised the World with its Quantitative Easing Announcement

Just when you thought the financial world would take a much-needed break from quantitative easing (QE), the Land of the Rising Sun comes in and juices up the markets with more QE.

The irony here is telling.

In the same week that the U.S. Federal Reserve shut down what was effectively “QE4,” with its announcement on Wednesday that its bond-buying program had ended, the Bank of Japan (BoJ) announced that it was turning up its printing presses.

The BoJ’s move took most market watchers — including myself — by surprise.

Specifically, Japanese policymakers announced that the BoJ’s annual target for expanding the monetary base would rise to 80 trillion yen ($724 billion), up from 60-70 trillion yen.

What does the BoJ’s move mean in practice?

It means that Japan’s central bank has committed to purchasing the equivalent of more than double the value of new bonds actually issued by the government. That’s a far greater amount than for any of the other bond-buying programs that have become fashionable among the world’s central banks, including the massive QE programs of the Federal Reserve.

Reaction to the BoJ’s move pushed the yen to a six-year low and sparked a rally in the Japanese stock market. It also helped fuel the big gains we saw on Friday in both the U.S. and global stock markets.

While the BoJ’s new monetary base expansion target dominated the headlines on Friday, we also learned that Japan’s Government Pension Investment Fund, the world’s largest pension fund, holding about $1.1 trillion in assets, also increased its allocation to stocks. Japanese and overseas stocks will now have a 25% weighting each, up from 12%.

This move, too, puts upward pressure on the Japanese stock market, especially over the long term.

A Furious Short-Covering Rally

The unexpected policy shift by the BoJ set off a furious short-covering rally in the Japanese stock market.

Prior to Friday, a whole lot of investors were betting against Japanese equities. In fact, as recently as Oct. 16, bearish bets made up 36.6% of all transactions on the Tokyo Stock Exchange. That was the highest level since the exchange started keeping records. Such a high degree of pessimism has been, without exception, bullish for the market. Historically, Japanese equities have rallied 9.7% on average over the following three months after a jump in bearish bets.

Sure enough, on Friday, the Nikkei 225 Average leapt 4.8% to a seven-year high, as the yen tumbled to its lowest level against the dollar since January 2008.

So, is this short-covering rally in the Nikkei a mere anomaly, or should the BoJ’s move be read as a long-term bullish force to reckon with?

It is my view that the rally in the Japanese stock market, along with the concomitant decline in the yen, is a trend that has legs, and that will likely continue for some time.

Here’s why…

Well, in addition to the basic economics of more yen (or dollars, or pounds or euro, etc.) chasing the same amount of securities, there is also the issue of politics.

For Japan, the BoJ’s move to turbocharge QE in order to stimulate the economy is an all-in bet to validate the economic policies of Prime Minister Shinzo Abe’s “Abenomics.”

Honor, Validation and Abenomics

To understand the context of BoJ’s move, we need to go back to December 2012, when Shinzo Abe assumed the duties of Prime Minister. Mr. Abe was swept into office by the Japanese electorate after promising to reinvigorate that country’s ailing economy and extricate the country from the decade-long vice grip of deflation.

Mr. Abe’s plan to stimulate Japan’s economy was dubbed the “three arrows” policy.

The first arrow was the economic stimulus provided through QE by the BoJ. Under the direction of Mr. Abe’s handpicked BoJ chief governor, Haruhiko Kuroda, the BoJ introduced its own version of money printing.

The second arrow was huge public-works infrastructure spending, a veritable panacea in the minds of politicians since the beginning of civilization. Recall that the Great Pyramids of Egypt, the Parthenon of Ancient Greece and the Coliseum of the Roman Empire were all infrastructure projects in their day.

The third arrow — and arguably the hardest to implement — was the introduction of structural financial reforms.

In the beginning, Abenomics worked. Japanese equity markets soared, and the yen fell sharply against both the U.S. dollar and the euro. That helped Japanese exports, caused a rise in inflation and resumed economic growth.

Unfortunately for Mr. Abe and his economic platform, the Japanese economy eventually ran out of steam.

Japan’s economic growth has essentially leveled off in 2014. On Friday, the BoJ halved its forecast for economic growth for the 2014 fiscal year to just 0.5%.

One big cause of the economic standstill was the government’s decision to raise the national sales tax in April to 8% from 5%. This move not only took money out of Japanese citizens’ pockets, but also resulted in a big drop in Mr. Abe’s popularity.

Japan’s Olympian Bull Market?

Friday’s surprise move by the BoJ can be viewed as a move to restore the honor and prestige that Abenomics first enjoyed, as well as to bolster Mr. Abe’s popularity.

So what does all this mean for investors?

I expect Japanese equities to continue to rally, even as the Japanese yen continues to devalue against the dollar.

And this is a long-term bet that I expect to last for the next half a decade or so — all the way until the Tokyo Olympics in 2020.

In case you missed it, I encourage you to read my e-letter column from last week about Warren Buffett’s recent stumbles. I also invite you to comment in the space provided below.