The recent backup in rates may be telling us that the market is afraid that the US will have to start paying even higher rates of interest in the future on its bonds if we are to fund our stimulus plans. Higher rates would of course mean, lower bond prices.
The comparison between our conditions and those Japan faced in the ‘90s provides clues on bond price moves. For me the message is, avoid long dated Treasurys. We might also be grateful if the worst we experience is a “lost decade” like Japan’s.
Just because Japan kept rates low and bond prices high longer than many people expected, doesn’t mean we’ll be able to do the same thing. Even though Japan’s economy was in some ways less robust in the ‘90s than in the ‘80s, its high savings rates and large trade surpluses meant that there was plenty of demand for Japanese Government Bonds (JGBs) at low rates. In other words, they had the economic conditions to support low rates over the long term. I’m not sure we can say the same.
Certainly Japan’s economy stagnated in the 1990s. Its stock and property markets have yet to regain their 1989 peaks. And despite their policies of public works spending and low interest rates, Japan prolonged its recession by propping up weak banks. Japan papered over the losses at these institutions, hoping that with low interest rates, even weak banks would enjoy fat net interest margins on new loans. That would enable them to make enough money to cover previous losses, the argument ran. It didn’t work, and eventually Japan had to get tough with its “zombie” banks.
Still, Japan has done much better than advertised. For example, during the last two decades Japan’s leading firms battled each other for world domination in autos and consumer electronics while US firms were out of the running. Think Toyota vs. Nissan and Honda, or Sony vs. Hitachi and Sharp. Not bad for a “failing” country. Japan has underplayed its economic performance in the press and this helped Japan defend and build its trade surpluses. Sometimes “misunderestimation” can really work for you.
The Japanese export machine – coupled with high domestic savings rates – gave Japan running room in the ‘90s that we don’t have now. They could afford economic stimulus and to keep dead banks walking. First, Japan’s high savings rate meant that Japan did not have to rely on foreign buyers for JGBs. Second, its trade surplus ensured demand for yen. Therefore, even though Japan was keeping rates low in order to prop up weak banks, the Japanese never had to worry about a crash in the yen. Indeed, with low rates, Japan got to reap the benefits of a weak currency in terms of keeping exports cheap, but with the trade surplus they never had to worry about the kind of devaluation that would be disruptive.
Unlike Japan’s our Government is looking at a tough funding problem. With our low savings rates and declining economy, we need foreigners to buy Treasurys in order to fund our budget. And that’s not all. Not only will we run fiscal deficits in the trillions over the next two years, we continue to run large trade deficits too. If you import fewer goods than you export, the only way to balance your books is to sell securities – and so we also need foreigners to buy our bonds in order to fund our import habit.
For the moment demand for our bonds and for dollars has held up mostly because other countries seem to be doing as badly as we are economically. The Eurozone’s banks are weaker than ours by some measures, and the Europeans are not sure how to coordinate their response. Asian countries dependant on US consumers are suffering export crashes too. Nonetheless the Asian economies and the Eurozone have higher savings rates and better trade balances than we do.
As Nixon’s economist Herbert Stein said, “If something cannot continue, it will stop.” So it may be with Treasurys. Sooner or later we may have to pay up in order to keep the Government funded. Today the 10 year note yields 2.90% and the 30 year bond yields 3.69%. The risk/reward on long Treasurys looks ugly.