Monday, March 14, 2011

Japan Disaster: Two Interest Rate and Oil Price Scenarios

Japan’s 8.9 earthquake and tsunami have produced a staggering toll in lives lost and disrupted. The value of the property in the area affected is about $300 billion, an estimated 14% of which is covered by earthquake insurance. Since our economies and markets are tightly bound together, Japan's economic response will affect U.S. interest rates and oil prices -- likely in a way that helps the U.S.

Japan’s central bank responded by pumping $183.8 billion into its economy to make up for the lost production and to pay for rebuilding the country. But this big addition to Japan’s debt, which before the quake had reached 200% of its $5 trillion GDP, is not resulting in a weakening of the Yen.

Rather, Japan is taking its capital out of its global investments, and bringing it home. Considering that $882 billion of that capital had been in U.S. government securities, representing 22% of the total $4.4 trillion worth of foreign holdings of those securities, according to the U.S. Treasury, that sell-off could lead to higher U.S. interest rates unless other investors step in to take Japan’s place.

Meanwhile, the decline in Japan’s more than four million barrel per day oil consumption, about a million of which evaporated in the quake's wake, could take pressure off of rising oil and gasoline prices. This could slow down U.S. economic growth. The answer depends on which of four possible scenarios on interest rates (higher or the same) and oil prices (higher or lower) unfolds in the coming months.

While theoretically, there are four possible scenarios, I'd guess these two are most likely and they're listed below in order of my guess as to their chances:
  • 1. U.S. interest rates unchanged, oil prices lower. Under this scenario, interest rates remain unchanged because the effect of Japanese investors translating their Dollars to Yen is offset by investors who pile into U.S. government securities as a flight to quality. Meanwhile, oil prices drop because 29% of Japan's oil refining capacity has been shuttered in response to the earthquake, thus reducing its daily consumption of oil by 1.3 million barrels a day, 29% of its 4.5 million daily consumption before the quake.
  • 2. U.S. interest rates unchanged, oil prices rise. Under this scenario, interest rates remain unchanged for the reasons mentioned above but oil prices rise as investors anticipate that Japan ends up consuming more oil to make up for its loss of nuclear power capacity. This scenario seems less likely because many analysts expect Japan to use natural gas and coal as the primary substitutes for nuclear power, that accounted for 30% of its energy supply.
Japan is the world's third largest economy. It could be months or years before it is rebuilt to the point that it can return to its pre-quake levels of consumption and production. This should take pressure off of rising prices that might boost inflation and cause the Fed to decide it needs to act by raising interest rates.

It's possible that Japan will shift some of its production of automobiles to U.S. plants since production has been disrupted in Japan. Similar disruptions in Japan's semiconductor industry --  it makes 40% of smartphone data storage chips and leads in making liquid crystal displays for tablets -- could create opportunities for U.S. competitors to pick up some of the slack. But the rebuilding will help some Japanese companies -- stock in Kajima, a major Japanese construction company, rose 22.1% today.

When combined with the removal of the braking effect of higher oil prices -- a $10 a barrel increase in oil prices reduces GDP growth by 0.5% -- Japan's economic pain could boost U.S. growth. But as images of last Thursday's disaster keep pouring in, I hope the rest of the world does all it can to help Japan rebuild.


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