Aug. 21 (Bloomberg) -- Life is getting tough for us Japan bears now that the Nikkei 225 Stock Average is zooming higher. Suddenly, there's little patience for negativity on the world's second-biggest economy.

Yet for those betting on a Japanese recovery, here are two words: bond yields.

While government bond prices rose today, they fell in the eight previous days, putting benchmark 10-year bonds on the road toward their longest losing streak since 1994. Ten-year yields fell to 1.385 percent today from as high as 1.485 percent Wednesday as higher rates attracted buyers.

In general, though, yields are rising as investors swap bonds for stocks, which are rising. The Nikkei is now at a 13-month high, and investors figure the rally will continue.

The irony here is that the very thing Tokyo has been hoping for -- a rising equity market -- threatens to hurt the economy. As the Nikkei rises and investors buy into the Japan-is-recovering hype, bond yields rise. A large and sustained rise in bond rates is the one thing Japan's economy can't handle right now.

If the yen rises, making exports less competitive, the economy will survive. If the Nikkei suddenly plunges, the financial system will stay afloat. After all, it has lived well enough with sliding stocks for 13 years now.

Financial Cannibalism

But a bear market in bonds is a different thing entirely, and the ongoing rise in yields has investors fearing one is afoot. The plot thickened this week after Tokyo's sale of 20-year bonds drew the least demand in two years.

Japan, simply put, is grappling with financial cannibalism. A recovery in stocks is cannibalizing demand for bonds and vice versa. Higher bond yields may presage a long-awaited rebound in Japanese growth, but also may choke it off.

The only way for the nation to break the pattern is for the government to step up reform efforts. That's not happening. The Nikkei isn't rising because Japan's fundamentals have changed, but because things are looking brighter in the U.S.

Admittedly, the Nikkei's 21 percent rise this year shows investors are betting on a recovery. Exports are picking up --they rose 1 percent in the second quarter -- boosting optimism about the outlook for corporate earnings.

Full Benefits

Yet a jump in bond yields will make it harder for Japan to reap the full benefits of stronger U.S. demand. Indebted companies will have a harder time profiting if bond payments increase. Households will have a harder time borrowing, leaving even less demand for credit. The government, which carries a debt load 40 percent larger than the economy, will have to give money that would be better spent stimulating the economy to bond investors.

Is a Japanese crisis afoot? It's unlikely, at least for now. Bonds are still the safest bet Japan-based investors can make. And the government will throw everything in its financial arsenal at the debt market to avoid a crisis. Japan's bond bubble may indeed explode, but the odds don't favor it happening anytime soon.

Yet all this says much about the precarious nature of Japan's economy and why investors should be careful rushing into the Nikkei. Tokyo remains locked in muddle-through mode, hoping to grow its way out of its problems. If you were unimpressed by the pace of financial reform here six months ago, you have plenty of reason to think there's even less going on now.

Plugging the Holes

Officials in Tokyo are masters of finger-in-the-dike economics. Nowhere will you find policy makers more adept at averting financial crises.

But then, that's exactly the problem. Japan has managed to avoid the revolutionary changes needed to make the economy strong and globally competitive. The only consistent policy these last 13 years has been papering over cracks and punting them forward to be dealt with down the road.

It's best to think of Japan as a big game of musical chairs; everyone's hoping the music doesn't stop while they're in charge, putting off painful change so that the next guy can deal with it. Because it's been able to avoid serious banking crises, Tokyo is under little pressure to change its tune.

That's why the economy falls prey to predictable cycles of panic and relief. The last panic period ended in early June after the government averted a crisis by bailing out Resona Holdings Inc., Japan's fifth biggest bank. Now we're in a relief period, characterized by calm in the banking system and rising equities.

Japan could be back in panic mode soon if bond yields continue rising. This week, the yield on the 1 percent bond due in 2013 rose to its highest level since March 2002. Debt is the main financial asset held by banks, pension funds, insurance companies, government-run institutions, and the postal savings system. If stocks fall, many companies and individuals get hurt; if bond yields rise, just about everyone does.

What Japan seems to be left with is a zero-sum investment environment. The dominant pattern is that bond yields fall when stocks rise and vice versa. One market can gain only by cannibalizing the other. Until something changes, today's rise in the Nikkei really is bad for bonds -- and the economy.

Last Updated: August 21, 2003 02:05 EDT