Guest Post: The Japanese Writing On The Walls

Submitted by NJB Deflator

The Japanese Writing On The Walls

With "unlimited" bond purchases confirmed by Super Mario and the ECB and the Fed essentially doing the same thing without calling it so, it is nothing short of integral to juxtapose the current western world central banking revolution with that of the Bank of Japan in the 80s.

Japan faced an asset bubble that forced the nationalization decapitation of many Japanese banks whose lending practices and balance sheets depended upon the appreciation of said frothy assets (mainly real-estate, sound familiar?), which threw the country into recession in 1990...four years after the crisis was considered to have begun.

Japanese 10-year Treasury yield (blue) and Japanese debt-to-GDP (green) since 1975

Interestingly, the bulk of Japan's debt creation (relative to GDP) did not actually occur during their crisis; the above chart clearly depicts how Japan's monetary accommodation followed their financial crisis as a way to help deleverage the economy smoothly (again, familiar?).  The result of that first round of dovishness has since rendered the Japanese economy addicted to debt monetization, as depicted by the unperturbed rise in debt-to-GDP.  The debt creation that was meant to bolster growth and counteract deflationary forces became the status-quo.  This is empirical evidence that once growth within a country becomes central banking-centric, it remains so.  Economies, like actual drug addicts, are not willing to revert to weaker highs.  Once market participants experience the windfall of "free growth" that monetary accommodation yields, they are not wiling to revert to traditional growth schemes.  This notion is wildly short-sighted, and the pursuit of such a growth scheme is barely sustainable without extreme measures (ahem, Japanese debt-to-GDP).

Supported by the Japanese debt-driven recovery as an analog to that of the United States, I propose that the United States can be considered in the early stages of amassing the same anvil of debt that has been weighing down Japan and kneeled the Japanese economy to the mercy of the Bank of Japan.

US 10-year Treasury yield (blue) and US debt-to-GDP ratio (red, not indexed as a %) since 1975

Japanese interest rates peaked in 1975, whereas US interest rates peaked in the early 80s.  These interest rate trends are the product of the accommodative central banking regime that presented itself in the 80s in the US, which I wrote a paper about.  Similar dovish actions undertaken by the Bank of Japan following the onset of their financial crisis have pushed down Japanese interest rates since said crisis.  The front and middle parts of the Japanese yield curve flattened to such a degree that 10 years following their financial crisis, their 10-year Treasury yield (and all paper of shorter maturity) hit 0%, and has remained at 0% since then.

Will the US follow the same path of balance-sheet-centric growth as Japan?  That remains to be seen, but the Fed promising easing while US equities are hitting multi-year highs is not a good sign.

Lest we forget that this time it will surely be different.

S&P500 (red) and the US 10-year yield/S&P differential (blue, Treasury yield minus S&P level, both indexed) since 1990    

...and all the quants said that mean reversion was dead!  Talk about range-bound: We see that the US entered into a vicious bubble-deflate-reflate cycle in the 90s and nothing indicates that this range should be broken anytime soon.  With the Fed's guarantee of further largesse, I'd say this relationship has a couple more good years to run...

Gold is still your friend.