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Is Europe (still) turning Japanese? A lesson from the 90’s

Seven years since the start of the financial crisis and it’s ever harder to dismiss the notion that Europe is turning Japanese.

Now this is far from a new comparison, and the suggestions made by many since 2008 that the developed world was on course to repeat Japan’s experience now appear wide of the mark (we’ve discussed our own view of the topic previously here and here). The substantial pick-up in growth in many developed economies, notably the US and UK, instead indicates that many are escaping their liquidity traps and finding their own paths, rather than blindly following Japan’s road to oblivion. Super-expansionary policy measures, it can be argued, have largely been successful.

Not so, though, in Europe, where Japan’s lesson doesn’t yet seem to have been taken on board. And here, the bond market is certainly taking the notion seriously. 10 year bund yields have collapsed from just shy of 2% at the turn of the year and the inflation market is pricing in a mere 1.4% inflation for the next 10 years; significantly below the ECB’s quantitative definition of price stability.

So just how reasonable is the comparison with Japan and what could fixed income investors expect if history repeats itself?

The prelude to the recent European experience wasn’t all that different to that of Japan in the late 1980s. Overly loose financial conditions resulted in a property boom, elevated stock markets and the usual fall from grace that typically follows. As is the case today in Europe, Japan was left with an over-sized and weakened banking system, and an over-indebted and aging population. Both Japan and Europe were either unable or unwilling to run countercyclical policies and found that the monetary transmission mechanism became impaired. Both also laboured under periods of strong currency appreciation – though the Japanese experience was the more extreme – and the constant reality of household and banking sector deleveraging. The failure to deal swiftly and decisively with its banking sector woes – unlike the example of the US – continues to limit lending to the wider Eurozone economy, much as was the case in Japan during the 1990s and beyond. And despite the fact that Japanese demographics may look much worse than Europe’s do today, back in the 1990s they were far more comparable to those in Europe currently.

Probably the most glaring difference in the two experiences is centred around the labour market response. Whereas Eurozone unemployment has risen substantially post crisis, the Japanese experience involved greater downward pressure on wages with relatively fewer job losses and a more significant downward impact on prices.

With such obvious similarities between the two positions, and whilst acknowledging some notable differences, it’s surely worthwhile looking at the Japanese bond market response.

As you would expect from an economy mired in deflation, Japan’s experience over two decades has been characterised by extremely low bond yields (chart 1). Low government bond yields likely encouraged investors to chase yield and invest in corporate bonds, pushing spreads down (chart 2) and creating a virtuous circle that ensured low default rates and low bond yields – a situation that remains true some 23 years later.

Japan and Germany 10 year government bond yields

Japan and Germany corporate bond yields

As an aside, Japanese default rates have remained exceptionally low, despite the country’s two decades of stagnation. Low interest rates, high levels of liquidity, and the refusal to allow any issuers to default or restructure created a country overrun by zombie banks and companies. This has resulted in lower productivity and so lower long-term growth potential – far from ideal, but not a bad thing in the short-to-medium term for a corporate bond investor. With this in mind, European credit spreads approaching historically tight levels, as seen today, can be easily justified.

Can European defaults stay as low as for the past 30 years

Europe currently finds itself in a similar position to that of Japan several years into its crisis. Outright deflation may seem some way off, although the risk of inflation expectations becoming unanchored clearly exists and has been much alluded to of late. Japan’s biggest mistake was likely the relative lack of action on the part of the BOJ. It will be interesting to see what, if any response, the ECB sees as appropriate on June 5th and in subsequent months.

BoJ basic discount and ECB main refinancing rates

Though it is probably too early to call for the ‘Japanification’ of Europe, a long-term policy of ECB supported liquidity, low bond yields and tight spreads doesn’t seem too farfetched. The ECB have said they are ready to act. They should be. The warning signs are there for all to see.

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How do house prices feed into inflation rates around the world? It’s important for central banks, and for bond investors.

After the collapse in real estate prices in many of the major developed nations during and after the Great Financial Crisis, housing is back in demand again. Strong house price appreciation is being seen in most areas of the US, in the UK (especially in London), and German property prices have started to move up. We’re even seeing prices rise in parts of Ireland, the poster child for the property boom and bust cycle. I wanted to take a quick look at what rising house prices do for inflation rates. Not the second round effects of higher house prices feeding into wage demands, or the increased cost of plumbers and carpets, but the direct way that either house prices, mortgage costs and rents end up in our published inflation stats. Also, the question about whether central banks should target asset prices is another debate too (there’s some good discussion on that here).

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There is no simple answer to the question “how do house prices feed into the inflation statistics”. It varies not just from country to country, but also within the different measures of inflation within one geographical area. But given central banks’ rate setting/QE behaviour is determined by the published inflation measures it’s important to understand how house prices might, or might not, drive changes in those measures.

The US

“Shelter” is around 31% of the CPI which is used to determine the pricing of US inflation linked bonds (TIPS), but just 16% of the Core PCE Deflator, the measure that the Federal Reserve targets. The PCE is a broader measure, with much bigger weights to financial services and healthcare, so shelter measures therefore have to have a smaller weight in that measure. The CPI shelter weight looks high by international standards. For the Bureau of Labor Statistics, the purchase price of a house is not important except in how it influences the ongoing cost of providing shelter to its inhabitants. The method that the BLS uses to determine what those costs might be is “rental equivalence”. It surveys actual market rents, and augments this data by asking a sample of homeowners to estimate what it would cost them to rent the property that they live in (excluding utility bills and furniture). You can read a detailed explanation of this process here. In both the CPI and PCE, pure market rents are given around a quarter of the weight given to OER, Owners’ Equivalent Rent. There are problems with this – and not just with the accuracy of the homeowners’ rental guesses. Having rents and rental equivalence in the inflation data rather than a house price measure means that you can have – simultaneously – a house price bubble, and a falling impact from house prices in the inflation data. We’ve seen times when a speculative frenzy means house prices rise, but the impact of that speculation is overbuilding of property (just before the 2008 crash there was 12 months of excess inventory of houses in the US compared to a pre-bubble level of around 5 months) leading to falling rents. The reverse happened as the US recovered. House prices continued to tank, but because of a lack of mortgage finance more people were forced to rent, pushing up rents within the inflation data.

The UK

How house prices feed into the UK inflation data depends on whether you care about CPI inflation (which the Bank of England targets) or RPI inflation (which we bond investors care about as it’s the statistic referenced by the UK index linked bond markets). House prices directly feed into the RPI, but because house prices have little direct input into the CPI, the recent trend higher in UK property will lead to a growing wedge between the two measures – good news for index linked bond investors! The RPI captures house price rises in two ways – through Mortgage Interest Payments (MIPs) and House Depreciation. Mortgage payments will increase as the price of property rises, but they will most quickly reflect changes in interest rates. For example Alan Clarke of Scotia estimates that a hike in Bank Rate of 150 bps would feed almost immediately into the RPI, adding 1% to the annual rate. This is despite the trend in the UK for people to fix their mortgage payments. Housing Depreciation linked to UK house prices with a lag, and is an attempt to measure the cost of ownership (a bit like the BLS’s aim with rental equivalence) but has been criticized as overstating the cost of ownership in rising markets as house price inflation is almost always about land values accelerating rather than the bricks and mortar themselves. Land does not depreciate like other fixed assets (no wear and tear). Housing is very significant in the UK RPI, making up 17.3% of the basket (8.6% actual rents, 2.9% MIPs, 5.8% depreciation).

The UK’s CPI is a European harmonised measure of inflation. It only takes account of housing costs through a 6% weight on actual rents. There has never been agreement within the EU about how wider housing costs should be measured! Countries with high levels of home ownership have different views from countries with a high proportion of renters. Housing is around 18% of the expenditure of a typical person in the UK, so the Office of National Statistics regards the current CPI weight as a “weakness”. They therefore are now publishing CPIH, which includes housing on a rental equivalence basis (the same idea that the ONS measures “the price owner occupiers would need to rent their own home” as a dwelling is a “capital good, and therefore not consumed, but instead provides a flow of services that are consumed each period”). CPIH has a 17.7% weight to housing, but remains an experimental series, and plays no part in the official monetary targets.

The Eurozone

The European Central Bank targets CPI inflation, at or a little below 2%. As mentioned above the harmonised measure that Eurostat produces does not include any measure of housing other than actual rents, with a weight of 6%. If you think house price inflation (or deflation) is important for policymakers this low weighting has probably never mattered since the Eurozone came into existence. Although there have been pockets of very high house price inflation (Spain, Ireland, Netherlands) because the Big 3, Germany, France and Italy have had very little house price movement I doubt that a CPIH measure would be terribly different. We are, however, now seeing some upwards movements in the German residential property market in “prime” regions – albeit it as Spanish and Dutch house prices continue to freefall. It’s also important to note the range of importance of rents within the individual countries’ CPI numbers. For Slovenians it makes up 0.7% of their inflation basket, but for the Germans it is 10.2%.

Japan

Housing makes up 21% of the headline CPI. Like the US CPI the Japanese statistical authorities use a measure of an “imputed rent of an owner-occupied house” as well as actual rental costs. Again the imputed rents from owner occupiers (15.6%) dwarf the actual numbers from renters (5.4%) – aren’t these large weightings to imputed rents here and elsewhere a bit worrying? How would you homeowners reading this go about guessing a rent for your property? I’d only get close by looking at websites for similar places to mine up for rent nearby. Is that cheating?

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So why does this matter? Well if there is no correlation between house price inflation and consumer price inflation then it probably doesn’t. But intuitively both the direct impact on wage demands of workers who see house prices going up, and the wealth effect on the consumption of those who see their biggest asset surging in value should be significant. Therefore central banks will be missing this if they use statistics where the relationship between house prices and their impact in those statistics is weak.

 

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Japanese investors are not buying foreign bonds, they’re selling

One of the stories that has driven global financial markets higher for the past few months has been about how Japanese investors are piling, or will pile, into foreign assets. Surely a rational Japanese investor would dump Japanese assets in an attempt to escape the exploding yen and the ravages of domestic inflation, or at the very least seek out a bigger yield than the puny returns available on the artificially suppressed domestic government bonds?

Well, they haven’t been buying foreign bonds; actually they’ve done the opposite. There were lots of headlines earlier this month after Japanese investors were (just about) net purchasers of foreign bonds in the three weeks to May 10th. But data out overnight showed that there were ¥804.4bn worth of net sales of foreign bonds in the week to May 17th, which more than reversed the previous three weeks’ purchases.

The chart below shows the weekly net purchases of foreign bonds, where the data is based on reports from designated major investors including banks, insurance companies, asset management companies etc. The blue line in the chart below is the 3 month moving average, and it shows that Japanese redemptions of foreign bonds are running at close to the highest rate since data began in 2001.

It’s difficult to deduce too much from all the data, but it appears likely that the rally in the Nikkei, the drop in the yen and the rally in semi-core Eurozone government bonds has been down to foreign investors front running something that so far has not actually happened. Japanese investors may still flee their domestic market, but it will require (mostly foreign) investors’ already high inflation expectations to be realised (the bond market is pricing in Japanese inflation averaging +1.8%pa for the next 5 years, despite there being little evidence that QE in Japan or other countries has succeeded in either generating inflation or in weakening currencies). It probably also requires changes to the higher capital charges that major Japanese investors face when investing in overseas assets, although even with this, funding costs and hedging requirements will ensure that home bias continues.

Bondvigilantes Japanese purchases of foreign bonds MR May 13

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Jim’s video from Tokyo – cup noodles, lessons about QE from the Edo period, and the fiscal multiplier effect

Last week Jim attended the annual meetings of the IMF and World Bank in Tokyo. For Bond Vigilantes, he took the camera along and documented his trip. Jim told me that the IMF and World Bank meetings, and even more the conversations and debates beyond the formal schedule, gave him some interesting food for thought. With the fiscal cliff arising and the UK’s failing experiment with austerity, Olivier Blanchard’s views around fiscal multiplier effects have been quite thought provoking. But not only has the conference helped shape his views, Tokyo itself has been inspiring. Much seems to be genuinely different, but at the same time there are many things that make you think Japan might be leading the way for the rest of the developed world.

Postscript: Anyone who was expecting further insights from Jim’s research trips into national sports will be disappointed. This time he didn’t bother to sight new football talent after his lack of success in Brazil. And he still prefers cricket over baseball…

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Currency wars

Recently, we have often spoken about QE, and how it could result in the demise of the bond vigilante (topsy turvy), and the birth of the currency vigilante. Well, we are getting very close to the presumed launch of further unconventional monetary policy by the Fed on the 3rd of November. The market is trying to work out if it’s shock and awe or a gradual siege mentality that the Fed will deploy. Quite interestingly, the Fed has been asking US bond dealers what they are expecting, and what the markets’ reaction to QE2 would be!

However, this is not a purely domestic issue. The currency vigilantes, as previously discussed, are likely to react by driving the value of dollars down, thus increasing potential inflation and growth in the USA. This is something the Fed would be keen on as long as the decline in the dollar does not become violent and disorderly.

The Fed, however, is not alone in its desire for lower unemployment in a low inflation landscape: many economies around the world face similar issues. This is best typified by Japan. The BOJ has put itself on a war footing and is ready to respond to the salvo the Fed looks set to launch on the 3rd of November. How do we know that? Well, they took no action at their last meeting on the 28th of October, but have brought forward the date of their next meeting to the 4th of  November, in order to respond to the Fed’s next round of QE.

As we know from recent currency intervention, the Japanese do not wish their currency to appreciate. So, how may they respond to the Fed? Well, presumably using simple supply-demand economics: in order to keep the yen at the same rate as the dollar they might have to simply match the Fed by printing an appropriate amount of yen, which could be described as unconventional foreign exchange intervention.

This all sounds very inflationary and very bond negative. However, if the vast sums of money that are created in the likes of the USA, Japan, and possibly the UK (70% of the G7 GDP) is initially deployed to buy back government debt, then the bond markets may have no choice but to bizarrely rally in this potentially higher inflationary environment.

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Bernanke calls for a 4% inflation target

Well sort of.  It hasn’t got a lot of attention in the bond markets, but this week both Jon Hilsenrath in the WSJ, and subsequently Paul Krugman in the NYT have revisited Ben Bernanke’s paper Japanese Monetary Policy: A Case in Self-Induced Paralysis.  Bernanke wrote this in 1999 as an academic at Princeton University.  In it he calls on the Bank of Japan to set a “fairly high” inflation target to show that it “is intent on moving safely away from a deflationary regime, but also that it intends to make up some of the “price-level gap” created by eight years of zero or negative inflation”.  Bernanke argues that an inflation target of 3-4%, to be maintained for a number of years, would give the private sector some confidence about the authorities’ desire to get away from the deflation trap.

The BoJ obviously took no notice of Bernanke’s paper, and over a decade on from its publication Japanese CPI is still very negative year-on-year.  The question is whether Bernanke’s plan to help Japan recover from the stagnation it suffered post the collapse of its commercial property bubble reflects his thinking on what the Fed should do to help America recover from the stagnation it’s suffering post the collapse of its residential property bubble.  Currently the Fed targets a long term inflation rate of just 2%, but also has an objective to maximise employment.  We’d argue that the Fed has generally put the employment objective ahead of the inflation objective – its reaction function has always been to wait for the unemployment rate to start falling before it hikes rates (the lag between unemployment falling and the Fed hiking has been especially long in the last two economic recoveries – see chart). 

However, a doubling of the US inflation target would cause carnage in the US Treasury bond market (who wants a 10 year bond yielding 2.7% when the Fed is targeting 4% inflation?) – and with one of the shortest debt maturity profiles of any developed economy, the interest burden cost of changing the target might be enough to trigger a credit rating downgrade (and in the medium term even a default?).  For this reason alone I think that Bernanke is unlikely to talk about a change in the target publicly (although others, including IMF Chief Economist Olivier Blanchard have been arguing for such a change).  Because of the political and public disregard for the runaway budget deficit, and the US Treasury’s behaviour in borrowing short to finance it (50% of the US Treasury market matures in the next 3 years), Bernanke’s hands might be tied.  The positive impact on private sector behaviour comes from loudly signalling a change in inflation behaviour, but the reliance on overseas investors to finance the US deficit makes such signalling very expensive, and possibly lethal.  So I don’t expect a change in Bernanke’s rhetoric around the inflation target.  But actions speak louder than words, and we will see the zero interest rate policy continue for the foreseeable future, and continued excursions into the world of quantitative easing.  As for the outcome of such policies, it would be foolish to put too much conviction as to whether the western economies end up looking more like Japan, or more like Zimbabwe.

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Turning Japanese I Think We’re Turning Japanese I Really Think So (follow up)

There is only one explanation for why 2 year US Treasury yields broke below 0.5% today (an all time low), or why 10 year government bond yields in Germany and the US are currently 2.5% and 2.9% respectively.  Or, for that matter, why German 30 year bunds are now at just 3.2%.  The bond markets clearly think there is a very real and increasing risk that the developed countries are going to end up looking like Japan. James Bullard of the Federal Reserve made this point in a recent academic paper, where he argued there’s a possibility that “the US economy may become enmeshed in a Japanese-style, deflationary outcome within the next several years”. 

It’s interesting to look back at how sovereign bond markets have moved since November 2008, when I last made the Japan comparison on this blog (see here).  In autumn 2008, the UK yield curve looked like Japan’s did in March 1995.  Just under two years later, and the UK curve and indeed many other countries’ yield curves look similar to Japan’s in May 1997 (see chart).

Is the market justified in believing that we’re turning Japanese?  Some may argue that the economic recovery in the developed world from early 2009 has looked distinctly un-Japanese.  Preliminary figures for real UK GDP in Q2 were +1.1% (unannualised), the fastest pace of expansion since Q1 2001. US GDP hit an annualised rate of +5.0% in Q4 2009 and +3.7% in Q1 2010.  While the recent estimate for US GDP in Q2 was a weaker +2.4%, global economic data (even in the US) is not (yet) suggesting anything worse than a modest slowdown.

However, Japan’s growth initially followed a similar path in the mid 1990s -  the year on year real growth rate remained positive in every quarter from Q2 1994 to Q3 1997, averaging a healthy +2.1%.  The problem was that what appeared to be reasonable growth was a result of a huge surge in government spending and monetary stimulus.  It wasn’t sustainable.  A lack of consumer demand, a broken banking system and falling asset prices then combined to feed into falling inflation.  Core inflation (ex food and energy) fell from 2.3% at the end of 1992 down to 0.5% in 1995-1996.  Headline inflation briefly dipped below zero in 1994-5, and both measures fell below zero in 1998 and have stayed there more or less ever since.  The Japanese authorities weren’t able to do much in reaction to this fall in inflation – monetary policy became ineffective once rates hit 0.5% in September 1995. 

The worrying thing for the developed world is that cuts in the Bank rate tend to take 18 months to have a full effect on an economy, and it’s perhaps no coincidence that the slowdown that hit the US a few months ago has come 18 months after the final Fed rate cut in December 2008.   The only path left for central banks is unconventional monetary policy, and is something that developed economies began last year.  While the policies haven’t been totally ineffective (the Bank of England estimates gilt yields are 1% lower as a result) and we’ll never know what would have happened without the extraordinary measures, money supply growth is still generally weak or falling.  Developed world economies appear to have fallen into a liquidity trap, as argued by Paul Krugman here.  This has serious consequences – if policy makers are running a Zero Interest Rate Policy (ZIRP) and inflation is falling, then real interest rates are rising.  And if the economy falls into deflation, then you have positive real interest rates precisely when you don’t want them, ie monetary policy is tightening.

The Japanese actually had a big advantage over us – thanks to Japan’s huge domestic savings, the authorities were able to channel a huge amount of money into the domestic government bond market and were therefore able to maintain huge budget deficits and run up massive public debt levels (public/debt GDP is now over 200%).  This fiscal stimulus is a luxury that most developed countries don’t currently have.   We’ve had unprecedented monetary and fiscal stimuli since Q4 2008, but bond markets are forcing most governments to withdraw fiscal stimuli.  Further stimuli would increase the risk of sovereign insolvency. 

So now, not only are we facing deleveraging in the household sector and the financial sector, but we’re also about to face deleveraging from the public sector.  The consequence of deleveraging ought to be lower growth and lower inflation and this appears to be happening.  Monthly headline US CPI has now fallen for three consecutive months, which has only happened a handful of times since the data series began in 1947.  Eurozone CPI is 1.4% year on year, and that’s even before the fiscal austerity has really started. The UK appears to be the exception, although while inflation is a concern as mentioned previously here, inflationary pressure can be largely attributed to the combination of a VAT increase and the lagged effect of previous sterling weakness (and note that sterling has strengthened about 8% since the beginning of March on a trade weighted basis so currency strength should soon begin to have the opposite effect).

If you take the old rule of thumb that a 10 year government bond yield should equal the long term growth rate plus the long term inflation rate, then it’s clear that bond markets are pricing in a grim scenario.  Other risky assets arguably aren’t though, and there’s a clear disconnect.  If the majority of the global economy does indeed go the way of Japan, I suspect that a lot of seemingly cheap assets will get even cheaper.

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The year is 2020, and the world is about to get hit by the next financial tsunami…(+ **competition time**)

The year is 2020, and at the centre of the financial tsunami is Japan.  Another decade of very low single digit growth has meant that debt to GDP has steadily climbed from 200% in 2010 to 300%, which is considerably higher than any other country.  Another ‘lost decade’ has meant that the Japanese government has been unable to meaningfully cut back on spending or increase taxes, since such behaviour would have risked plunging the economy back into recession and deflation.   Nominal tax revenue has been static for twenty years.   Worsening demographics have meant that social security costs have skyrocketed – in 2010, 23% of the population was above 65 years old, but this has risen to 30% in 2020. 

All the things that kept Japanese government bond yields so low through the 1990s and 2000s have begun to unwind.  Demand from the postal savings and postal insurance systems, which held over 30% of all JGBs in 2010, has begun to wane due to the meagre returns on offer in domestic savings.  The public pension fund, which held 12% of JGBs in 2009, is steadily redeeming its holdings, since JGBs no longer meet the fund’s required return, and the fund has had to sell assets to meet rising cash outflows.   The average individual’s savings rate has steadily fallen, in line with the rapidly aging demographic (the propensity to consume for pensioners is about 120%).  Japanese institutional and private investors have traditionally exhibited exceptionally strong home bias, holding over 90% of outstanding JGBs, but domestic demand has rapidly weakened as globalisation of financial markets and the lure of greater returns on overseas assets have resulted in domestic investors diversifying geographically.   

Financial markets are getting deeply concerned that Japan will struggle to service its debts.  Japanese investors are worried about the Japanese authorities attempting to inflate their way out of the problem and are increasing exposure to overseas markets.  A wave of selling has meant that the Yen has weakened and  Japanese government bond yields have started to rise sharply.  The rise in yields means that the maturing low-coupon JGBs that were issued 10-20 years ago are having to be replaced by higher coupon bonds.  Interest payments on sovereign debt are rapidly approaching tax revenues.  The Yen is not a global reserve currency, and Japan can’t rely on capital inflows from abroad to fund its deficits.  The country is on the  brink of getting junked by the rating agencies.   Financial markets are wondering what happens when one third of the world’s government bond market defaults in one go. 

The year is 2009 again.  Thankfully, the nightmare scenario above hasn’t happened, but how realistic is it?  Rising sovereign indebtedness has been a very hot topic over the past 12 months (I wrote about it in June here), and having recently read an excellent research note from JP Morgan (which I’ve drawn from heavily above), it’s entirely plausible that Japan could be at the epicentre of a sovereign debt crisis. 

A wave of sovereign defaults becomes all the more plausible if you read ‘This Time is Different : Eight Centuries of Financial Folly’, which is the recent publication from Carmen Reinhart and Ken Rogoff (Rogoff almost uncannily foresaw the collapse of Lehman Brothers – see here).  The book is based on two highly influential academic papers published last year, (This Time is Different : A Panoramic View of Eight Centuries of Financial Crises and The Aftermath of Financial Crises), and is a ‘must read’ for any bond investor.  Looking back over the centuries, they highlight that at the moment we’re in a typical lull in sovereign defaults, one or two decade lulls in defaults are not uncommon, and each lull has invariably been followed by a new wave of defaults.  History tells us that there have been numerous periods where a high percentage of all countries are in a long period of default or restructuring.           

I suppose that the goodish news is that if the terrible scenario described in the first three paragraphs above does occur, then it’s very unlikely to happen anytime soon.  A high sovereign debt to GDP ratio does not mean that paying interest on the debt is necessarily that difficult – again citing JP Morgan, Japan’s debt service cost in 2008 was a very manageable 2.6% of nominal GDP, smaller than the US’s 2.9% and the Eurozone’s 3.0%.  Sovereign debt levels are – for the next few years at least – easily sustainable in Japan and the rest of the developed world.

Another piece of good news is that default or restructuring is not inevitable. Canada is a good example of a country that lost its AAA rating in the 1990s, cleaned up its balance sheet, and is now one of the world’s strongest sovereigns (although Canada was arguably in a much stronger position in the mid 1990s than much of the world is in today). 

The reaction of the authorities around the world to this crisis over the past year is, in my view, to be greatly admired.  There have been mistakes and delays, but errors cannot be helped when such huge decisions need to be made in such a short period of time.  The world has experienced much pain, but we can only guess at how many more times worse it could have been.  There is no doubt, though, that some of the biggest challenges lie ahead, and as highlighted in the horror scenario above, if politicians fail to take brave and decisive actions over the coming years, then things will get much, much worse.  These are issues that politicians are very aware of, but dealing with them is easier said than done (as an example, you can read about how Germany is trying to tackle the issue here).

Finally, we have a copy of Reinhart and Rogoff’s book mentioned above for our readers.  The quantitative easing multiple choice question is this – on Thursday this week, how much will the UK’s MPC decide to extend asset purchases by – (a) nothing (b) £25bn, (c) £50bn or (d) other?  The first correct answer drawn out of a hat later this week wins. To view the Terms and Conditions of the competition, please click here.  Once you have read the T&C’s , please use the ‘get in touch’ function on this blog to enter.   

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Does deflation always result in a low and flat yield curve?

We’ve had a huge rally in risky assets since we wrote a comment about Turning Japanese almost a year ago, and while diminished, the risk of a ‘lost decade’ is still very real. I thought it would be worth another look. Now I am not out to compare and contrast the prevailing conditions that led to deflation and QE between Japan and the UK, but what I want to do is ask whether deflation, which led to QE in both countries, necessarily means stubbornly low and flat government bond yield curves, as it did in Japan?

As a brief reminder, the Japanese experience began with the property and equity bubble bursting in 1989, followed by weak growth and deflation through most of the 1990s.  As people know, the Japanese response was much slower that what we’ve seen. The Bank of Japan (BoJ) hiked rates to 6% half a year before the economy entered recession in March 1991, and cut incrementally towards zero over the next 4 years, well into the country’s contraction.  The BoJ waited almost 3 years after entering deflation before beginning QE.  And, as a comparison, the Bank of England has bought back a bigger percentage of the gilt market in only six months than the BoJ did at any   stage, and has approval to do even more.

As we have discussed in previous blogs, deflation is a dire scenario for central bankers and policymakers, destroying the efficacy of monetary policy. But when the deflationary psychology sets in to an economy and its agents, it could also have horrific consequences for the economy through consumer spending (which represents about 70% of our economy’s output), as people cease spending. Why would we buy a new fridge, say, today, if we know that in 1 year’s time it will be cheaper? It is really with these fears in mind that authorities in the US and UK in particular have reacted so quickly and substantially, and why we are repeatedly told they would "rather do too much, than too little".

Looking at the difference between 10 and 2 year government bond yields in the UK and Japan when QE started, we can clearly see that the UK curve is substantially steeper than Japan’s yield curve. This suggests that the markets are as yet not expecting the curve to flatten a la Japan. Why might this be? Well, firstly, it may be because unlike Japan, the Bank of England has been quick to react to deflation and has been aggressive in its response. So the markets have perhaps interpreted the level of stimulus as being sufficient to stave off anything like a lost decade of growth due to a fall in aggregate demand leading to a deflationary spiral. In other words, QE may have done enough to reignite inflation.

However, I think a significant reason is to do with the constitution of the two markets, namely the proportion of government borrowings owned by foreign investors. In Japan at the time of QE, approximately 3.4% of JGBs were held by foreigners. This is a sharp contrast to the government bond markets the US and UK.  Today, 36% of outstanding gilts are owned by foreigners. This is a huge difference, and it adds to my hunch that deflation, even if it were to persist in the UK, would not necessitate very low and flat yield curves. With only 3.4% of JGBs owned by overseas investors, Japan could proceed with an inflationary stimulus programme and not worry about an exodus of foreign demand for their bonds, or about an influential foreign buyer network demanding higher JGB yields for the (perceived rising) risks.

Japan could print money, thereby putting negative pressure on the Yen without overdue concern about not being able to borrow the requisite funds. Contrastingly, the US and UK are constrained in regards to inflating out of a large debt burden and devaluing the currency, since foreign owners fleeing government bonds would put huge upwards pressure on government bond yields. This is a big issue for the US at the moment, with China owning over $800bn of US Treasuries (see here for full list).

Painful adjustments undoubtedly lie ahead as government expenditure is cut, as taxes rise, and as the nation’s balance sheet is rationalised and delevered. And if this is done sufficiently and appropriately, there is no reason foreign holders will flee the currency or the government bond markets. And we actually take our hats off to the authorities for recognising the dangers of a deflationary spiral that could so easily come from the complete shut-down of the credit mechanism in an economy. Now for the second, and every bit as important part: withdrawing the stimulus at the right time so as to avoid hyperinflation and a collapsing currency.

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What effect will the surge of government bond issuance have on government bond returns?

This is a question that numerous clients and members of the press have asked us so I thought it would be worth writing a brief comment here. 

Focusing on the UK, in yesterday’s budget, chancellor Alistair Darling said that gross gilt issuance will be £220bn this financial year, which is easily a record. There is much speculation as to whether the market is able to digest this much issuance.  If there is a lack of demand, or ‘indigestion’, then prices will have to fall and yields to rise until appetite for gilts returns.  

The chart shows the relationship between gross gilt issuance in each fiscal year since 1991 against the total return from gilts in that period.  There is no relationship.  It’s also a similar story if you measure gilt issuance as a percentage of GDP, or look at net gilt issuance rather than gross gilt issuance.

A lack of correlation is not to say that it doesn’t matter if the supply of government bonds is huge – clearly it does matter.  The law of economics says that if the supply of something increases, then all else being equal, the price will fall. But with regards to government bond issuance, all else does not remain equal.  When governments issue lots of bonds, it generally means that the economy is in trouble.  And if the economy is in trouble, it means that spare capacity is probably being created because unemployment is going up and wages are stagnant (or perhaps even falling).  These things all put downward pressure on inflation.  If inflation falls and interest rates are low or falling, then locking into a high fixed interest rate (at least ‘high’ relative to cash interest rates) is very attractive, and demand for government bonds increases. Yields therefore fall and prices rise.  This is exactly what happened last year in the UK – 2008 was the biggest year for gilt issuance but was still a very good year for gilt returns.

What will cause demand for gilts to rise over the next year to equal or exceed the supply of gilts?  It depends on what happens to inflation and economic growth.  In terms of inflation, Alistair Darling  projects CPI to fall to 1% this year, and RPI to fall to -3% in September before rising to zero next year.  In terms of growth, he expects -3.5% for 2009, +1.25% for 2010 and 3.5% for 2011. 

Slightly ironically, gilt investors should be hoping that the chancellor has overestimated his growth forecasts, even though this will inevitably result in the budget’s numbers not adding up and even more gilts being issued than projected.  Gilt investors should hope Alistair Darling is wrong because if the chancellor is correct about +3.5% growth in 2011, the economy will be booming at its strongest pace since 1999 and you can be pretty confident that government bond yields will be quite a bit higher. 

Much can happen between now and 2011, and his growth projection is certainly possible, but at the moment our view is that it is unlikely that UK growth will be this strong.  If UK economic growth does indeed fall short of his projections, then it’s also likely that inflation will fall short too.  And if your core scenario is that sterling won’t collapse (which would put upwards pressure on inflation), then gilt yields are very capable of going lower.

Finally, as we’ve mentioned previously on this blog, don’t forget what happened to Japan.  There are of course many differences between the UK and Japanese economies, but an important lesson is that large issuance doesn’t mean government bond yields must rise.  The OECD expects Japan’s ratio of public debt to GDP to rise to 197% next year, more than two times as much as for France, Germany and the UK (see chart).  Japanese government debt has tripled since 1996.  And yet today, 10 year Japanese government bonds yield 1.4%, and got as low as 0.4% in 2003.

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