Japan has become our petri dish for central bank efficacy.  Much of the market action over the last few weeks has been driven from news coming from Japan.  When the Yen strengthens, markets fall and vice versa.  The question everyone is asking is whether central banks are heading down the right path or bound to lose control.

If you look at flows in the United States, the shift has been made towards floating rate or short duration debt and into cyclicals, small cap stocks, and even Japanese equities.  It seems that the 50 bps backup in interest rates has many investors feeling that interest rates are finally on their upward move.  You even have former chairman of Goldman Sach’s Jim O’Neill telling everyone to get ready for 4% 10 year treasury yields.

If the world is so filled with sunshine, why is the 10 year breakeven inflation rate in the United States falling:

And if the economy is counting on some support from a slowly recovering housing market, then how exactly will that housing market recovery react to a sharply rising mortgage rate:

To be honest I think we have just one elephant in the room and certain investors are reacting to short term technicals rather than the underlying over-arching issue:

Will Abenomics Work?

Look at the Yen, the Nikkei and 5 year Japanese breakeven rates.  They are all the same thing.  If Abe can’t ignite some inflationary pressure then the whole central banking foundation comes crumbling down:

Yen = Nikkei = Expected Inflation

Since the middle of May the Abe formula has been in doubt.  If the Abe formula is in doubt for Japan, then it certainly should raise flags for central banks around the world.  Japan is just much further down the path of deflationary destruction.  Let’s just hope that Japan’s 3.5% reported Q1 GDP and later revised upward to 4.1% (because the 5/15 number didn’t seem to impress) is real.  Otherwise it might just be a long summer and fall trading season.