Dear Valued Clients and Friends,
For a long time, there was only one country on earth dealing with a bubble that had burst, spending way more than it was bringing in, seeing revenues decrease, juggling banks that weren’t actually solvent, and running extreme monetary policy to try and keep all the holes in the dam from bursting. That country was Japan in the 1990s and into the next decade. For over 30 years now, they have favored radical fiscal and monetary policy as a means of dealing with their economic woes, and the result has been well-documented in these pages of Dividend Cafe.
The balanced budgets and high real GDP growth rates of the American economy in the 1990s went away when our own credit bubble burst in 2008. Asset prices fell, deficits exploded, and the Fed played pharmacist to it all, providing ample medicine to make it all feel better as we muddled through.
Japan now has ample company to the fundamental shared sickness of “excessive indebtedness.” Across the developed world, those Japan-like characteristics of high debt, muted growth, and monetary discretion are now par for the course (see: America, Europe).
Today we’re going to look at a few things with Japan and see if we can’t learn a little about the future state of the American economy and policy. It is one thing to refuse to learn from the past. It is another thing altogether to not even learn from the present.
Let’s jump in to the Dividend Cafe …
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Reincarnation
James Carville famously said during the Clinton presidency that he wanted to be reincarnated as the bond market, a reference to the power that the bond market possesses in the modern economy. One thing that needs to be pointed out – those who have lent money to others actually do not have power if there is to be no more borrowing; the borrower would have all the leverage, and all the creditor (lender) could do is pray they are paid back or seek some recourse through collateral capture or legal action. When the borrower is a sovereign country, there is usually not much collateral, and lenders to countries aren’t usually banking on the goodwill of their borrower. Rather, the reason the lender/creditor/bond market has so much power is precisely because of the knowledge that the borrowers need to constantly come back and tap them for more money. Borrowers only have leverage if they have gotten their money and do not need more; when they need to borrow and borrow again, it behooves them to pay back on time. That is the essence of the power of the bond market – it knows that its borrowers need it and will need it in perpetuity.
Anyone for a refinance?
The 10-year bond yield in Japan has been basically zero percent for six years. Now, there was actually over a year where it was NEGATIVE – where borrowers PAID money for the privilege of lending Japan money – and right now, there is a 0.41% yield on a 10-year Japanese bond. So a range of +0.5% to -0.5% has held for quite some time. It’s good money if you can get it.
By comparison
The U.S. and Japanese bond markets have decoupled in the last year for a reason we will talk about shortly. But over the last few decades, we have seen U.S. bond yields collapse, landing around 2% for many years post-crisis (and even below 1% during COVID) before a recent move into the mid/high 3’s. Even that move from 2% to 3.6% is barely noticeable on the long-term chart of the 10-year yield compared to the secular downward pressure of the last forty years.
But one of these things is not like the other
Yield Curve Control is a monetary policy tool whereby the central bank of a country both states an intention and acts on that intention to keep certain bond yields at certain bond maturities at a certain level or within a certain range. There was a lot of speculation during COVID that Powell and the Fed would utilize yield curve control, though they didn’t end up doing so (explicitly; many would argue they enjoyed an implicit yield curve control, and I wouldn’t disagree).
How does a central bank do this? They say, “We want our yield curve to look like this …” (with X as the yield for a 2-year and Y as the yield for a 10-year, or whatever other maturities you want to use), and then they go out and buy enough in the market to make that yield come true.
They are their own bond market
Japan’s central bank can make these things happen by becoming the bond market. They are essentially half of their own bond market right now …
This chart is extraordinary. And it speaks to a huge weapon the Japanese central bank has used to affect their monetary policy – yield curve control by owning the bonds themselves.
Now, plenty of insurance companies, pension funds, and even foreign investors were content with these yield-less bonds as well, though that latter category warrants some further dialogue.
Neighborly assistance
Foreign investors are net sellers of Japanese bonds now, though it wasn’t always that way, even in this yield-less decade.
Households represent a much smaller part of the investor base for funding Japanese debt, so if they can’t generate interest there, the central bank has to do more and more of the funding. I really don’t think this is that hard to piece together:
(1) The government has borrowed so much money they need very low rates on the debt
(2) Very low rates on bonds keep foreign investors and/or domestic savers away
(3) A lack of foreign investors and domestic savers to fund the bond market makes the central bank have to do more
(4) The more the central bank does, the more interest rates are kept near zero
(5) A lack of capital flows means a lack of investment, a lack of productivity, and a lack of growth
(6) A lack of growth means more government spending and borrowing
(7) More government spending and borrowing means the need to keep rates low, which means … (start this chart all over again)
Over here in the red, white, and blue
One of the most comically wrong predictions of the drama queens over the last 10-15 years has been the idea that there was about to be a lost appetite or market for U.S. Treasuries. The Fed went from 10% to 20% of our Treasury bond market, and people speculated that if the Fed stopped buying, there would be no buyers. Foreign buyers went from 44% to 31% of total issuance, and people speculated there would be no buyers. From 1985 to 2015, U.S. investors (banks and households) went from 80% to 40% of the market, yet Treasuries rallied more than any time in history. Essentially, as each of these three categories of buyers has waxed and waned, another’s demand has increased. Right now, we see the central bank actually reducing its level of ownership (quantitative tightening) and domestic investor appetite actually increasing. Same as it ever was.
But …
Market rates have mostly driven our treasury bond market, even as massive Fed QE has penetrated the market. Yes, the Fed wildly distorted things, and yes, their objective with QE3 back in 2013-14 was to manipulate the long end of the curve down. But they didn’t become more than 20% of the bond market, and when the Fed exited, we did not see a substantial move higher in yields (paradoxically, bond yields went down each time a quantitative easing round ended). And as you see from the chart above, the appetite for U.S. bonds from other actors besides a central bank is a huge blessing for the U.S. Japan used to have it, too, but not anymore.
What can we learn from this?
But by the grace of God?
It strikes me as incredibly arrogant to assume that the United States would never have to engage yield curve control as a monetary policy tool. From a zero interest rate policy to aggressive bond buying (quantitative easing), the Fed has followed the Bank of Japan’s playbook out of the last two crises (COVID 2020 and GFC 2008). A variety of competitive advantages kept us from having to go “full Japan” (that is, implore yield curve control). Does anyone doubt that our own Fed would use its playbook further if conditions so warranted? I don’t.
Japanese banks, funds, trust accounts, and such are massively increasing their purchases of foreign instruments. They have flatlined in their ownership of U.S. treasuries (it was about $1.1 trillion ten years ago and is still $1.1 trillion today, though that is down from $1.35 trillion a couple of years ago).
Will domestic investors and savers here in the States ever shun treasuries for foreign bonds? Will banks? Is Yield Curve Control a potential cause of that happening, or would yield curve control have to happen as a result of it hypothetically happening? What we know is that the U.S. has the same milieu (excessive indebtedness and stagnating growth) that made them implore various measures. Those fiscal and monetary measures were mostly shared by the U.S. and Japan but have thus far not required the additional intervention of yield curve control and have not yet evaporated foreign demand for U.S. bonds. The glide path makes me think it is if, not when.
What else?
When you end up having to buy a lot of foreign bonds to get your desired exposures, the currency can take away all the returns. You can hedge currency risk, but that almost assures one of a negative return (because of the cost of hedging). Negative returns from one’s bond market scare away investors, which invites more central bank intervention. You end up with downward pressure on interest rates that kill bank profitability. Net Interest Margin in major Japanese banks is less than 1%, while it is 2.5% here in the States (and that is way too low). You do get a very low cost of funds in Japan compared to the U.S., but, ummmm, who cares? If there is no appetite for projects, capex, growth, etc., or not worthy borrowers, how does a low cost of capital help?
Japan’s lesson is that it does not.
Conclusion
Will the U.S. learn any other lessons from Japan, or will they follow the same path down this stagnating hill? From demography to monetary intervention to sustaining zombie banks to growing debt-to-GDP indebtedness to massive fiscal deficits, in all cases, Japan has tried them all without the desired effect, and the U.S. has either followed suit or is playing a game of catch-up.
And in the end, without stopping down that path, the end result is yield curve control, a larger Fed, more bank failures, more zombie companies, and, yes, stagnating growth. It begs for a more creative and daring, and audacious Fed than the one we have had for the last 15 years.
Ultimately, it will likely cause us to one day look at “yield curve control” as a laughable policy tool compared to the ones I bet are coming.
Quote of the Week
“You don’t have to agree on everything if the one thing you agree on is important enough.”
~ Bono
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We are into the final month of the first half of the year and ready for it all. Reach out with any questions or comments, and have a wonderful weekend. We can’t persuade American policymakers to learn from the lessons of Japan, but we can convince our clients to follow our lead through these unsettling times. To that end, we work.
With regards,
David L. Bahnsen
Chief Investment Officer, Managing Partner
dbahnsen@thebahnsengroup.com
The Bahnsen Group
www.thebahnsengroup.com
This week’s Dividend Cafe features research from S&P, Baird, Barclays, Goldman Sachs, and the IRN research platform of FactSet
