How significant is the Bank of Japan’s decision to join the Fed and ECB in draining liquidity?
Powers: The obvious risk in financial markets is that this joint liquidity draining by the Fed, ECB and BOJ will prompt an exit from carry trades that have compressed risk premiums in rate and spread markets around the world. The reversal of these carry trades should lead to normalization of currently compressed risk premiums. BOJ policy has been the anchor for carry trades, providing a reliable and large pool of money that hedge funds, proprietary traders and asset managers have used as a source of cheap financing for carry trades. The status of these carry trades will depend largely on where the BOJ moves the overnight discount rate (ODR). PIMCO expects only a modest move, something less than what the market has already priced in. Our Japan team’s expectation is a single quarter-point move in the ODR in the remainder of 2006 and a second quarter point move in 2007, for a total of only a half-a-percent move in the ODR. A half-percent move would result in a zero real rate in Japan base
