Following Japanese Models?
Perhaps those sage English philosophers 'The Vapors' were on to something 32 years ago when they asked if we were "Turning Japanese" for it seems the following charts from Nomura certainly suggest the US bond market is heading in that direction. From demographics to monetary policy; from investor allocations to flows; and from bond bubbles and volatility to long-term interest-rate paths, it seems we share a lot more than a love for sushi and pachinko with our neigbours across the ocean as we seem to be chasing after many Japanese models (of asset allocation and macro-economics).
In the three years since the Great Recession ended, real GDP has grown at a lackluster 2.2% pace. Demographics play some role among structural factors holding back the recovery. The US and Japan are both dealing with an aging population and lower birth rates.
Slower population growth coupled with a greater share of the population aged 65 and older likely enhances the degree of risk aversion on average. Moreover, based on the life cycle model, elderly people tend to de-cumulate savings, which means less investable money. A natural conclusion of these arguments is reduced money flow into risky assets/real estate such as equity and homes.
On the monetary policy side, the Bank of Japan is a pioneer of non-conventional monetary policy tools including QE and a commitment to the future path of the policy rate. In March 2001, the Bank of Japan introduced a quantitative easing target, which was designed to increase the size of the current account balances held at the Bank of Japan, mostly bank reserves. At the same time, they committed to continue the quantitative easing until “deflationary concerns were dispelled.”
Much is made of the Fed being faster and bigger in the extreme monetary policy experiment than the BoJ was - as seen below...
Some limits of the Fed’s monetary policy: Based on the past experience, BOJ launched new asset purchase programs after the Great Recession under which they extended their scope to private risky assets (ETFs and REITs) (Figure 1). This is the direction of evolution of BOJ’s QE. However, the FRB technically is not able to purchase private assets. Given that the agency MBS market is not likely to expand in the near future, the Fed would face liquidity issues if they continue QE3 for an extended period. Moreover, in terms of setting quantitative thresholds to end the zero interest rate policy, the Fed should care more about the balance between inflation risks and boosting economic activity than the Bank of Japan.
However, after all that QE by the BoJ, they remain in a far worse place now than 20 years ago (from an economic point of view, an equity market perspective and a sovereign debt / leverage perspective) and perhaps the US has merely to revert to reality.
Investor Allocation To Bonds
The most apparent difference is that over the past 20 years, the US domestic investor base has reduced its UST exposure overall, whereas Japanese domestic investors have increased their holding of JGBs. This is important because many in the marketplace seems to assume that the Japanese have always owned JGBs and thus have always been able to finance their debt internally, whereas the US needs foreign investors to buy its debt. This also means that currently, US investors start from a lower base and thus have the potential to allocate more to USTs if they wished.
Japanese JGB buying had to start somewhere – and the accumulation phase began soon after their bubble burst. Prior to 1989, the investment culture in Japan was very similar to the US in the 1990s and 2000s (i.e., not risk averse). Currently, US Treasury buying has already started to pick up among the domestic investor base, similar to the ramp up in Japan around the mid-1990s. We continue to believe that more UST buying lies ahead with the domestic investor base.
Where's the bond bubble there?
We understand we cannot just extrapolate the trend of the JGB’s buyer base to see what is in store for USTs. And we reiterate that we do not believe that US investors will follow exactly the Japanese example. But even if we only see half of the sort of government bond buying behavior that occurred in Japan, we can expect US domestic accounts to acquire large amounts of UST debt in the years ahead.
Even a small convergence to the Japanese multi-year government bond buying trend by US investors will result in sizeable amount of UST buying (in terms of percentage of assets in government bonds). This buying could occur across many investor types that are currently hovering around multi-decade low allocations to USTs. The current global regime, with UST continuing to benefit from the flight to quality bid amid crises elsewhere, as well as the regulatory need for high quality collateral, should add tailwinds to the UST story of the domestic buyer base revival.
Corporate Bond Spreads and Volatility
One of the most frustrating outcomes from the Japan’s lost decade, especially when QE and ZIRP were in full effect, was the declining trend in corporate borrowing, where Japanese corporates were more inclined to pay down debt than take on new debt, even with zero rates. Corporate deleveraging was at play as companies grew defensive after the Japan credit crisis and attempted to keep inventory and capital investments below cash flow generation.
The same deleveraging process has been happening in the US, but we saw very different reactions by corporate borrowers. US corporates seized the moment of low rates for longer, first thanks to the FDIC guarantee of bank debt right after the crisis, and then the Fed’s unprecedented easing responses brought back the animal spirits in the debt markets and hence investor demand went further out the credit spectrum.
The chart above nicely sums up the different trends in corporate issuance in US versus Japan. In this chart we plot the quarter-on-quarter growth, on a 1-year rolling basis the increase in the total size of the credit markets in the US and Japan. We indexed both countries credit growth rates to the start of their QE programs (2001 for Japan and 2009 for US). Despite the fact that both governments took bold measures to avoid corporate bankruptcies and each central bank introduced monetary easing, the US managed to keep issuance in positive territory.
However, we caution that just because policy rates were anchored for years in Japan, it doesn’t mean that there wasn’t spread volatility (as is clear in the chart above). Moreover, there was a limit in how tight spreads went as well. We highlight above the unique credit dynamics amid low rates.
And Finally, take a look at these 6 charts... Are We Really Turning Japanese?
We really think so...