One of the more interesting side issues this week will involve whatever decision or non-decision the Bank of Japan makes with regard to additional quantitative easing measures.

As is almost always the case it isn’t the news that is important but rather the market’s reaction to the news. Those favoring a weaker yen may end up being disappointed if the BOJ’s decision fails to exceed expectations. From our perspective, however, the real key lies with the Japanese bond market. The fairly simple point is that 10-year Japaneseyields- currently close to 1.34%- not only have to rise but should movebriskly through 2% if Japan is ever going to push out of deflation. In a perfect world our outcome of choice to ‘the news’ would be a tumbling Japanese bond market. Time will tell.

At top right we show a comparison between the Japanese (JGB) 10-year bond futures, the spread between 30-year and 5-year U.S. Treasury yields, and the share price of Japanese bank Mitsubishi UFJ (MTU).

We have argued that MTU tends to bottom when the yield spread reaches a peak so with the spread potentially at the highs a case can be made that MTU is close to some kind of price low. On the other hand to turn the trend for MTU positive the Japanese bond market has to turn lower and as the chart rather clearly shows that was most certainly not the case as trading began last week.

Japanese yields did begin to rise somewhat through the final two days of trading last week- perhaps in anticipation of more aggressive easing by the Bank of Japan and some sort of commitment to a return towards rising prices.

The Bank of Japan’s last run at quantitative easing ended in early 2006 and in short order Japan slipped right back into deflation. Our view, by the way, is that much of what transpired during 2007 and 2008 was a direct result of the negative trend that  began to emerge in 2006 when the apparent declaration of monetary victory by the BOJ turned instead into a deflationary rout. The ratio between the share price of MTU and gold prices (GLD) peaked through the end of 2005 and has been attempting to make some sort of bottom over the past twelve months. A positive trend for the banks should go with some kind of downward pressure on gold prices so our hope is that no matter what the BOJ decides the reaction by the markets in the days to come leads to an upward swing in this ratio.

Equity/Bond Markets

We are going to go back over two charts that have captured our interest over the past while. At top right we show the share price of Mitsubishi UFJ (MTU) and the ratio between Japan’s Nikkei 225 Index and the Japanese 10-year (JGB) bond futures.

The argument is that the share price of MTU tends to trade quite closely over time with the Nikkei/JGB ratio. When the ratio was somewhat flat around 80 back during 2004 and into 2005 MTU was trading around 8. When the ratio rose to 130 at the start of  2007 MTU was trading around 13. On the bounce in 2008 the ratio rose to 110 as MTU bounced up to 11. And so on.

The argument is that MTU’s trend is a function of both the Japaneseequity and bond market so it will lag the Nikkei when the bond market is rising and outperform when the bond market is declining. With the Nikkei/JGB ratio currently trading around 77 a case can be made that MTU is somewhat ‘low’ as it trades in the 5’s.

Below we show a comparison between the share price of GlaxoSmithKline (GSK) and the ratio between U.S. equities (S&P 500 Index) and commodities (CRB Index).

The chart runs from late 1994 to the present day. The idea here is that ‘in general’ the share price of GSK tends to trade quite closely with the ratio. For example back in 1995 the ratio was 2:1 while GSK traded around 20 and at the peak in 1999 GSK reached 75 while the  ratio rose to 7.5.

The collapse in the equity/commodity ratio in 2008 down to 2.7 preceded what has so far proven to be the lows for the share price set in 2009 at 27.

Our focus is on how the equity/commodity ratio handles the resistance line around  4.2. If new highs are set this year then on a macro basis we can make the argument that GSK in particular and the pharma sector in general is trading with a fairly reasonable tail wind.