INSIGHTS

On August 19, 2019

AAM Viewpoints – The Japanification of the Global Economy

Examining Risks of Sub-Zero Global Interest Rates

The state of global interest rates is sinking quickly. Negative interest rates have now engulfed over $15 trillion of global sovereign debt with nearly 30% of all developed country sovereign debt having a negative yield. The U.S. 10-year Treasury yield is within a few basis points of its all-time low yield of 1.37%, which was reached in July 2012 and tested again in July 2016. Negative yields mean that lenders pay borrowers to take their money versus the normal function of lenders receiving interest from the borrower. Remember that there are significant risks taken by the lender of money. The two biggest are credit risk (the borrower’s ability to repay) and duration risk (the risk to the value of the note given future interest rate moves). The only way that a lender or investor can make a positive return on a negative-yielding bond is either if 1) rates move more negative thus allowing the investor to realize a higher price of their bond or 2) for the currency that the debt is denominated in to strengthen during the term of the instrument.This is not normal and is, at some degree, dangerous. The risks are likely not contained to the countries whose yields are negative but may also impact the rest of the global economies.

There is little precedent for negative interest rates and since there are likely no classes in universities worldwide that teach a chapter on negative interest rates, let’s examine the long-term effects of high government debt and asset value deflation as witnessed in Japan over the past 40 years. 

Japan’s stock market and real estate market hit their highs in December 1989 when the Nikkei 225 hit 39,957. The chart below shows that over the next 40 years this index has not recovered and trades today at roughly 20,500 which is about half of what it was at its peak (50% deflation).

Let’s compare that to interest rates in Japan during the same 40 years. The chart below shows that during that Japan’s interest rates have fallen precipitously. The Bank of Japan (BOJ) has been lowering interest rates well below those of the rest of the developed economies. Even as rates fell, however, bond investors were able to experience a higher total return as the currency strengthened over the same period.

The next graphic the yen over the same period as compared to its U.S. dollar equivalent. One can see that the yen appreciated from roughly 250 yen to the U.S. dollar to around 105 yen to the U.S. dollar today. Over 40 years of deflation led to the currency’s 138% appreciation over that period. This might seem counterintuitive given that global central banks are trying to weaken their currencies by cutting rates below zero. One can see that it doesn’t always work that way. During periods of deflation, the purchasing power of currency rises. This is just the opposite of inflation in which the purchasing power of currency weakens. If you think about it, if housing prices are dropping 5% per year that means that the same amount of currency will buy more home next year than this year. Thus, the currency’s purchasing power has in fact appreciated. Higher currency values also make exported goods and services less competitive with goods and services that are in the market from cheaper currency countries. Japan is, and always has been, an export-led economy. Why is an appreciating currency a problem? It is a problem because it kills demand for asset consumption. Like the house that decreases in price year-over-year, there is little desire to purchase the house if prices are spiraling down. Buyers will put off transactions if prices are deflating. This is the evil of deflation and why central banks fight it so much. Nobody wants to repeat Japan’s last 40 years.

The BOJ has been combatting this by putting the yen printing press in high gear over the past 10 years and buying all types of financial assets. They have been voraciously buying equities and debt in an attempt to weaken the currency by spurring inflation. In fact, in November 2018, Reuters reported that the total number of assets owned by the BOJ exceeded Japan’s GDP. The article reported that the 553.6 trillion yen ($4.87 trillion) of assets the BOJ holds are worth more than the entire Japanese economy. To add perspective, that is more than the GDP of Turkey, Argentina, South Africa, India and Indonesia combined.

How did the BOJ amass enough wealth to make these huge purchases? They printed it. Yes, the BOJ literally created yen from thin air and went to the open market and made huge purchases. The BOJ has become the world’s second central bank, after the Swiss National Bank, to own a pool of assets bigger than the economy it is trying to stimulate. They call this “quantitative and qualitative easing;” economists call it monetization of financial assets.

The BOJ’s actions are now being replicated by other global central banks including the European Central Bank (ECB) where sovereign interest rates are firmly negative across Europe. The Wall Street Journal reported that even countries with junk-rated debt, like Greece (remember default in 2010), produced a net yield of only 1.98% at their 10-year bond auction in July, compared to over 2% for the 10-year U.S. Treasury. We think something is very wrong with an asset market when junk yields are lower than those on prime-rated debt.

At the July 31 meeting of the Federal Open Market Committee (FOMC) a decision was reached to cut the U.S. Fed Funds rate by 25 basis points and end the run-off of assets that the Fed had bought as a part of its quantitative easing (QE) accumulation since 2008. This reverses the Fed’s position of bleeding down its hoard of bonds and puts it back firmly into QE mode. The global central bank QE asset-buying binge is now back in full swing with printing presses buzzing overtime to create the massive amounts of currency needed to quench the buying appetite.

So, what is wrong with this picture? Back to the opening sentences of this article. It is not normal to have a financial asset, like debt, priced such that the investor or lender is guaranteed to receive a negative return for the risk taken. It is like trying to live on a planet without oxygen. It defies the laws of economics and investing. The comparison to Japan is relevant because they have fought negative economic growth and deflation with low interest rates for 40 years and have little success to show for it. For the last 10 years the BOJ has been on a buying spree that is unprecedented in history and still cannot generate more than a slight puff of inflation. Why are the other central banks going down the same rabbit hole when there appears to be little long-term success? It is because they have no other tools to combat the creep of deflation.

History somewhat supports the thought that lower interest rates and excessive currency printing will weaken a currency’s value and produce an inflationary trend. The thought is that if you double the amount of currency outstanding and at the same time reduce the total number of financial assets outstanding then the value of each currency unit will drop. Much like a pie cut up in more pieces just makes each piece represent less of the whole. Thus far, the traditional thoughts surrounding QE have not worked. It is likely that since nearly all central banks are engaged in this practice, the competitive effects are muted. Competitive efforts to devalue currency have come to the shores of the United States. It is likely not going to end well.

There are several other risks that are being created by this global buying binge. Some are obvious and some not so obvious. The obvious risks include the fact that savers are penalized for QE. Bond buyers tend to be conservative in nature, willing to accept a defined future return for lending their money. Since there are no returns now to be had in the debt markets it forces them to take more risk by buying other assets that still have a positive yield. For a pension fund manager trying to generate a return to meet their known liabilities, this can get somewhat scary. This is exacerbated for unfunded liabilities as the current cost to fund claims goes up dramatically when the expected returns drop. In an aging population with more drawing on these unfunded liabilities, the effects can be even more problematic.

Source: CNN Money

Secondly, prices for assets that are being fueled by central bank buying can be pushed up to levels that are artificially high when the central banks that buy them have no price discipline. There is no price discovery when the markets are dominated by big buyers that must hit an asset-buying target based on a set amount of currency. The lack of natural buyers and sellers setting market prices is a real danger. This is one of the ways we have gotten to a point where bond prices are so high that they produce a negative return. When the demand for an asset, such as bonds, reaches an all-time high while the expected return from that asset is the lowest in history, we have a great example of a bubble.

Finally, if prices of bonds are in a bubble then where is the greatest risk if and when that bubble bursts? The risk will be felt by anyone who owns bonds. The greatest risk is likely to be borne by the central banks that have gorged on the asset class using printed money. Finding a buyer for these assets would be nearly impossible if the price bubble did break. I cannot find anywhere in history when central banks globally have grown their balance sheets by this level, and I think that we just don’t know the extent of the risks.

History has made it clear that asset bubbles inflate until they fail. The failure here could be a major central bank, triggered by a major sovereign failing or currency tanking. We don’t know. In the meantime, it is a good time to borrow money and a bad time to be the lender. Investors’ need to be very cautious when investing in bonds based on the historic conservative reputation of the asset class. Although this situation could go on for years, we are beyond the levels of risk ever recorded in history for the debt markets. We expect the outcome might be outside of history as well.

CRN: 2019-0801-7588R  

AAM was not involved with the preparation of the articles linked to in this commentary and the opinions expressed in these articles are not necessarily those of AAM.