US Vs. Japan Redux? A Credit 'Compare And Contrast' From BofA's Jeffrey Rosenberg

Much has been said about the comparison between Japan and the US on a macro level, as both countries succumb to the deflationary forces of social-wide deleveraging. Yet few have analyzed the transition of the US into Japan from the perspective of corporate credits. Below is BofA's Jeffrey Rosenberg, arguably the firm's best analyst, sharing what he sees as the arguments "for" and "against" the credit markets on America's one way road to Japanification. 

Is the US becoming Japan?

Arguments for and against in the credit markets

From the fixed income market perspective the obvious implication of turning Japanese would be a secular bull market in bonds. Such trends appear underway and the decline in rates validates the “Japanification” scenario. Amid the similarities however, critical differences in the structure of credit  markets likely allow a greater transmission of monetary policy accommodation into the real economy, eventually. Recent signs point to this potential,  though admittedly little of policy accommodation has reached the real economy and most of its inflationary consequences have resided in the financial economy.

Bull market in bonds belies “Japan” scenario

Exhibit A in the US as Japan scenario is the bull market in bonds. Figure 1 highlights the similarities between Japan interest rates after the bursting of its asset price bubbles in 1990 and the US post credit crisis. Extrapolating these trends makes it clear to us were the US to follow the road of Japan, a secular bull market in bonds and lower long-term interest rates would result.

Four lessons of Japan

Comparing the US and Japan on a macro economic basis reveals many similarities and differences. We repeat their “four lessons”: 1) Adopt an aggressive monetary policy response; 2) Heal the banking system quickly; 3) Avoid prematurely removing support; and 4) Ineffective policy can be expensive and lose popular support.

From the market perspective, the aggressive monetary support and the banking system response stand as the clearest differences between the US and Japan. Figure 2 depicts the relative shape of the yield curve between the US and Japan at similar points in time relative to the crisis. The consequence of the much more rapid monetary policy response relative to Japan has resulted in a much steeper yield curve. That steep yield curve in turn encourages a faster healing of the banking system in the US.

Faster healing of the banking system…

As our economists highlighted, the faster degree of recapitalization of the US banks (at least large US banks) contrasts to the extended period of “zombie” banks as Japan policy makers employed a strategy of regulatory forbearance. In the US, while residential and commercial real estate trends may most closely resemble this pattern, for corporate exposures the trends look decidedly more favorable in the US. For example, the recent Fed senior loan officer survey highlighted that both demand and supply for commercial credit in the US appear to be stabilizing.

…and less reliance on the banking system

Another critical difference between the US and Japan lies in the structure of their credit markets. In addition to the slow monetary policy response  (lesson #1), the failure to address quickly the banking system (lesson #2) led to a failure of monetary policy transmission into the real economy. In Japan, the vast majority of credit flows through the banking system – both for consumers and corporates. In contrast, the US financial system underwent a dramatic period of disintermediation in the period leading up to the credit crisis as the growth of securitization and public bond markets gradually moved credit intermediation into the public arena and away from private (banks) balance sheets. Figure 3 on the previous page highlights the differences in credit disintermediation between Japan and the US.

Disintermediation allows greater flexibility for policy accommodation to work into the real economy. The record pace of issuance in corporate bonds for example illustrates how the corporate sector directly benefits from lower interest rates (Figure 4). For consumers, lower rates are now spurring another round of mortgage refinancing leading to lower interest expense for consumers (Figure 5).

And while little of that activity has yet made it into the real economy, the backdrop of both cash on balance sheet and credit market availability means  that unlike in Japan, the ability to finance growth on corporate balance sheets does not stand as an impediment to any recovery. Similar to Japan however is the current lack of willingness – reflective of a lack of confidence in the business sector to spend. The rapid steepening of the yield curve in the US in contrast to Japan has led to a shift out the curve in investor demand for credit. This has allowed corporations to reduce the risk on their balance sheets by extending maturities of debt leaving balance sheets more rapidly repaired in the US case, putting US corporates in a better position to spend if confidence were to return to do so.

Credit likes disinflation…

Another implication of the Japan scenario for the US is the performance of credit assets. A consequence of the previously mentioned lack of  disintermediation in Japan, most credit exposures rested on bank balance sheets. The policy of forbearance in recognition of bad assets meant that  credit losses were deferred for years in the Japan scenario. This artificially lowered what reported and actual loss rates would have been under the deflationary environment of the time.

A look at the US history of deflation however yields a clue as to the potential performance of credit assets under a protracted period of falling prices.  Unlike today’s current period of falling inflation (disinflation), declining rates and compression in credit spreads has led to asset class leading returns for credit.

…but hates deflation

Servicing fixed debts with declining revenues spells increasing credit risk. This fact is clearly borne out in the default experience of the US during the  depression – the only sustained period of deflation in US history (Figure 6). Of course, the large increase in defaults was associated with large price declines. More modest deflation would be less negative for defaults but clearly as the figure suggests, the relationship of defaults to deflation is highly non-linear and a small increase in deflation could lead to large increases in corporate defaults. Moreover, as the overall price level falls the risk associated with further declines would likely lead to larger spread widening further undermining corporate performance.

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All of this merely goes to show why futher QE is inevitable, as the Fed hopes that further tightening in Treasury spreads continues to bring corporate spreads in, forcing corporates to continue to refinance at record low rates. Yet the biggest problem, which nobody wants to address, is the decreasing prevalence of cash-flow generating assets. As this most scary phenomenon is appreciated more and more by the investing community, the rates on debt will not matter, as no matter how close to zero these get, the record corporate debt overhang (yes, it goes hand in hand with the overhyped cash on the sidelines), just like USTs, will never be repaid. Case in point: the reemergence of 100 Year bonds (and the surprising willingness of investor to bid these up).

Comments

[Millennial]

I'm too lazy and hung over to walk to the bathroom to piss. I think I'll use the cat's litter box.

[Oswald Spengler]

Japan: Land of sliding doors and slant eyed whores.

[chrisd]

That's pretty crass, let's try and keep ZH clear of racist comments.

[centerline]

So, if I got this right (and ignore the banker bullshit), we Americans managed to learn from the Japanese and as a result significantly shorten the timeframe from boom-bust to utter destruction.  Wonderful.

[Spalding_Smailes]

Well if Mr. Rozenberg is right I guess we only have about 50% downdraft on housing over the next 10-12 years.

The only cures for asset deflation (mainly in real estate assets) are a recovery in property demand via expectations of economic growth and improvement in asset operating profitability. This may sound like a simple tautology, but in a situation where the economy continues to retreat amid a financial crisis, demand for real estate will not recover until a severe enough drop in prices significantly reduces the downside risk of holding property. In Japan’s case, it took 15 years for real estate prices to hit bottom, and it is unlikely that earlier government action might have halted the slide at a higher price level. Even if it could have shortened the process and duration of the crisis, the government probably could not have prevented the drop in prices.

http://www.pimco.com/Pages/Japan%20Credit%20Perspectives%20Aug%202008.aspx

[Woland]

Japan has been a disciplined society through centuries.

US is a society only handled through fear.

[thebone]

Is ZH really pimping Jim Cramer's website in the advertising section?

Too damn funny.

[fuu]

That would be google ad sense.

[Threeggg]

TD Just wanted to say thanks for all the heads up in the last year that I have been a member of ZH for.

I have gained a wealth of knowledge and recommend ZH to everyone I meet.

We all know you have been working OT getting this stuff out to us.

I find myself on ZH more and more...............!

again thanks

P.S.

Strap on your seatbelts

"This is going to get Ugly" !

[alexwest]

##Below is BofA's Jeffrey Rosenberg, arguably the firm's best analyst

well if he's the best,, and it was the his best shot.. 
you can start shorting Bofa right now,, :)

everybody who's says US has 10+ years ala Japan to go 
IS COMPLETE bonehead... its that simple..

here's explanation.. next crisis is going to be sovereign
crisis: US GB Italy Spain ,, you pick..

lets analyze fiscal situation in US and compare w/ Japan.
this fin year Japan gov will print 1 yen for each 1 yen in taxable income..
thus its 100% budget deficit in terms outlays/revenues..

US next year will print 0.8 $ for each $ 1 in axes.. 
2 trln$ intaxes, 1.6-1.7 is printing... so deficit is 80%..

so US is just 1,2 year behind Japan ... actually its worse here..

in Japan its 90% domestic bond market..nobody can sell Japan bonds..
Japan gov will get you.. in USA around 50% of public debt 
is in foreign hands .. Japanese, Chinese,, etc..

so.. what gonna happen if China will dump some holdings.. rates are up..
so debt servicing is up,, US gov revenues are down.. so budget deficit is up,, 
so FED will print more money,, more dumping.. etc etc 
its called self feeding.. and in the end HYPER INFLATION.. that will be end of GREAT AMERICAN EXPERIMENT..

good luck
alex

[Gonzalo Lira]

"Sound and fury, signifying nothing"—typical analyst BS. 

The charts also don't shed any interesting light, except to point out the obvious: Both economies contracted after a credit binge. 

GL

[williambanzai7]

TURNING JAPANESE

http://williambanzai7.blogspot.com/2009/11/american-yakuza.html

[Paper CRUSHer]

Ohh Arr,so i see yar plannin' yer next voyage mee fine fellows.Why i sea.......yar aimin' to follow dem a'japs down to thee bottom of thy deep red sea(of debt).Shiver mee timbers.......tis foolish to act dis waay. Why not just open yer Fort Knox treasure chest and monetize al'dem whee doubloons ya plundered. Show the blasted world once n' fur' all yer' not shitwrecked as they (paper gold)claim.Arr, t'we meet again me shitmates......ar'ship sets sail......ar'next port.....good'ol Jackson Hole to meet up wit' thee ol'Skipper Ben'........Captain of the gud ship-USS Fiat Titanic.

[Herry12]

Thanks for such a great post and the review, I am totally impressed! Keep stuff like this coming!...
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