Remember Japan

Investors would prefer to forget in face of low long-term rates.

September 1, 2010

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Japan LanternsIn anticipation of roving bands of Vikings, Vandals and Varangians, Europe is opting for a hair-shirt of austerity, with swingeing cuts to the welfare state. Deficit financing is regarded as low-hanging fruit for marauders armed with the latest Moody’s rating on sovereign debt, Fitched out to filch the unguarded flitch of bacon.

But hold on. Instead of the bond vigilantes sending debtor nations into the standard poorhouse, they’re marking real return bonds – the next best thing to gold – to near-deflationary levels. How does that work?

First, consider quantitative easing. That’s the next step after ZIRP – the zero interest rate policy Japan has been following for more than a decade. (Last week, it reconfirmed a 10 basis point overnight rate – 0.01% – sending the yen to 15-year high.)

But before that, the U.S. Federal Reserve announced that it would start selling the mortgage securities it had accumulated from Fannie Mae and Freddie Mac to raise cash to buy Treasury securities. In inflationary times, the Fed forces banks to buy Treasury securities to reduce lending. In deflationary times … the Fed does what it can to encourage lending (or at least liquidity).

The result is a great return for existing holders of nominal bonds, who receive a capital gain, and lousy for real return bond investors, who, in the absence of visible signs of inflation, seem to be taking a hit, as Treasury Inflation Protected Securities now have negative yields. What that actually means is that TIPS investors are only expecting to get their capital back – forget about the coupons.

Madness, right? Not according to one notable Japan deflation expert:

“Here’s a thought for all those insisting that there’s a bond bubble: how unreasonable are current long-term interest rates given current macroeconomic forecasts? I mean, at this point almost everyone expects unemployment to stay high for years to come, and there’s every reason to expect low or even negative inflation for a long time too. Shouldn’t that imply that the Fed will keep short-term rates near zero for a long time? And shouldn’t that, in turn, mean that a low long-term rate is justified too?”

So says Princeton professor Paul Krugman. Adding up economic indicators, chiefly unemployment and core inflation, he gives his 10-year prediction, based on short-term exigencies:

“That’s right: four years of near-zero short-term interest rates. Does a 10-year rate of 2.6 percent still sound so unreasonable? And bear in mind that I’m not using some doomsayer’s forecast; I’m using the staid folks at the CBO…my sense is that a lot of people just can’t bring themselves to face the reality that we’re likely to be in a zero-interest world for a long time. They just keep assuming that the Fed is going to raise rates soon, even though there is absolutely nothing about the macro situation that would justify such a rate increase.

But once again: if you take standard economic forecasts seriously, they point to near-zero short-term rates for a very long time, which in turn justifies low longer-term rates.

Remember Japan.”

Alas, Japan is something many investors would prefer to forget.

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