US Set for Japanification?

The path of US interest rates has reversed sharply this year, leading to legitimate concern over whether the US is destined for Japanification. Japanese policy rates peaked at 8.25% during a financial bubble that burst in 1989 and were then steadily trimmed until a zero interest rate policy (ZIRP) was finally introduced in 1999 (Chart 1). The path of US rates has lagged by 16 years with a bubble peak in 2006, but otherwise looks similar. And T US 10-year yields have followed an even closer (lagged) path to Japanese yields than has been the case for policy rates (Chart 2). If the post-bubble Japan analogue holds for US bonds, then sub-2% yields could persist for another 15-20 years.

Growth and Public Debt: Two Key Similarities

1. Growth – Japan grew strongly through the late 1980s but then stumbled badly after 1990, which set the stage for tumbling interest rates and bond yields. By contrast, US growth was solid through the 1990s but has weakened since 2000. Indeed, since 2000, annual average real per capita growth in Japan has been 1%, while it has fallen to 1.2% in the United States. This sustained US growth slide is the most powerful factor legitimizing the idea of a ‘Japanification’ of US bond yields, in our view.
2. Public Debt – Japan’s bond yields declined even as net public debt spiralled (Chart 3). Two factors were responsible: significant reliance on fiscal easing to promote growth in the aftermath of the bubble bursting in 1989, then, in the past 15 years, the primary culprit for rising debt has been the country’s bleak demographics (an aging and shrinking population). The US has experienced a rise in its net debt since 2001 that is tracking Japan’s, reflecting a similar combination of fiscal easing and underlying deterioration due to adverse demographics.

But There Are 4 Important Differences:

1. Equities – Japanese equity prices hit an all-time high in 1989 and today are not much more than 50% of that level. By contrast, US equities have risen substantially from their most recent low (in 2009Q1, Chart 4). In Japan, low equity prices have been important in depressing bond yields. In the US, low bond yields have been a key ingredient in promoting higher equity prices.
2. Currency – The evolution of JPY was a critical factor in shaping Japanese markets in the years after the bursting of the bubble in 1989 (Chart 5). In the decade from 1985-1995, JPY appreciated in real effective terms by about 80%. By contrast, USD depreciated through the build-up to its financial crisis in 2008 and soon after, with USD reaching its weakest point during 2011. JPY strength was a major headache for the BoJ, helping to create a deflationary mindset.
3. Savings – The Japanese private sector’s net financial balance (savings less investment) jumped in the aftermath of the bursting of the bubble (Chart 6). The rise was especially pronounced in the corporate sector. This sustained corporate desire to save (and reluctance to invest) created downward pressure on domestic interest rates that translated into the path for JGB yields highlighted earlier. The US’s path differed after its own financial crisis. There was a significant jump in the private sector’s net saving balance in 2009 (as investment collapsed), but this quickly unwound, and a net surplus has been maintained through the recovery. This reflects a bias towards caution in the private sector, which we think has been good for the prospects of sustaining the expansion.

4. Real Estate-A final key difference between Japan and the United States, which we think relevant to the path of relative equilibrium long-term bond yields, are those in the paths of inflation across the spectrum: assets, goods and services, and labour. 5 years after the bursting of the bubble, US land prices began to turn up; 5 years after the bursting of Japan’s bubble, they had 48% further to fall nationally before hitting bottom.

A similar story holds for both core consumer prices (Chart 7) and cash wages (Chart 8). The relative price path between the two economies did not diverge much until 5 years after their respective bubbles burst (i.e., about year 10 in Charts 7 and 8 – in Japan’s case the mid-1990s; in the US case, about 2011).

Bottom Line

Despite important similarities, we think the differences between the two are more numerous and more significant – most importantly the domestic inflation environment. Another significant difference is the wider global economy. Japan was alone when entering an extended phase of ZIRP. Now, unconventional monetary policy is closer to the norm, and significant portions of the European bond market operate with negative yields. We think these are likely to be a more significant driver of sub-2% US yields, and so this could be on the cards.

Phil Suttle is the founder and principal of Suttle Economics.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs)