Unless you really follow the markets, and I mean really follow them, you might have missed the relatively sharp drop in longer-term interest rates over the last couple of months, especially for US Treasury securities. This rally in bonds came to a crescendo, hopefully, this week when the 10-Year Note hit a yield-to-maturity of less than 1.3%. This was/is the lowest level since February, and begs the question: how now brown cow?
Interest rates are little more than the price of money. Historically, the price of money has generally been higher than the expected rate of inflation. After all, inflation erodes the purchasing power (or value) of money, and folks understandably don’t like that. That is until, apparently, they do.
As I type here to today on 7/9/21, the bond market expects inflation to be around 2.2% over the next 10 years. This is math: the yield of the ‘on the run’ 10-Year Treasury MINUS the yield on the ‘on the run’ 10-Year Treasury Inflation Protected Security (TIPS). Intuitively, IF the yield on the 10-Year is less than the expected rate of inflation, the yield on the TIPS issue must be negative, which is it.
Understanding this can get confusing in a hurry, let me put it this way: Treasury yields are lower than current and forecasted levels of inflation. That means the purchasing power of these investments should diminish over time. Not surprisingly, I don’t like that trade, at all.
This week, a client asked me in a text whether I felt the US was going to turn into Japan. By that, he meant stubbornly low interest rates and economic growth for an extended period of time. It is a fair question, and I told him I didn’t think this would be the case. While there are similarities, the differences in our situations far outweigh them.
Japan’s economic stagnation is the result of a financial system collapse in the early 1990s. As many reading this will remember, the Japan’s export-driven economy grew like gangbusters throughout the 1980s. The led to ‘upward pressure’ on the value of the yen relative to the US dollar. This scared the Bank of Japan, as the US was that country’s primary export market at that time. The thought process, which is valid, was a stronger yen would make Japanese-made products more expensive for US consumers. This would lead to decreased demand and, therefore, a smaller trade surplus.
As such, the central bank in Tokyo kept its version of the overnight lending target as low as it could for as long as it could. Further, it would frequently try to manipulate it in the global currency markets, as maintaining a weak yen become a matter of vital national importance. This led to a feverish economy, as the Japanese economy drowned in cash. Compounding the situation where some prohibitive estate tax laws which, somewhat perversely, led to a surge of debt-driven real estate purchases (I will spare you the details).
In a lot of ways, it was a perfect storm of tax policy, monetary policy, and economic policy blunders which led to arguably the biggest asset bubbles of the 20th Century. Things got so overheated that market value of the land of the Tokyo Imperial Palace (0.89 square miles) was worth more than all of the real estate in California. Craziness.
Seeing this as potentially bigger problem than a stronger yen, the Bank of Japan somewhat dramatically changed course, and began raising its overnight rate to ‘cool off’ this speculation. The problem is it went too far, too fast, and too long, and the Japanese economic/asset bubble popped. Unfortunately, the Japanese central bank did just about everything wrong at this point, as did the Japanese themselves. The bank kept credit too tight for too long as prices plunged. It propped up insolvent banks, leaving them with little way to grow and no way to fail. The markets eventually called them zombie banks, which was/is an apt term. Further, the Japanese consumer went into a shell, paying off what debt they could and saving as many yen as possible. The end result was ruined balance sheets and zero demand. Ta da!
One more thing, all of this was happening just as the Japanese population began to stall. From 1992 to 2020, it grew roughly 1.1 million, which is almost negligible growth. Intuitively, fewer young Japanese means more older Japanese, and people tend to spend less as they age. Further, their tolerance risk tends to diminish, and lower levels of risk taking will lead to lower absolute results over time. You could not have drawn it up any better, that is if you were painting a picture on how to stifle economic activity.
For all of our problems, the US is different. First, while asset prices have surged over the last couple of years, the present situation pales in comparison to late 1980s Japan, specifically Tokyo. Second, the US financial system is way under-leveraged, with the loan/deposit ratio at US banks currently hovering around 60.6% (in aggregate). While the US is aging, our population is still growing, having added over 85 million new Americans since 1992. Further, starting in 2029, more Americans will be turning 35 than 65, and the US should see a stabilizing of the median age. Finally, the Federal Reserve is not the Bank of Japan, and the US economy of the 2020s is very different than Japan’s in the 1980s.
Different countries, different cultures, different monetary policy objectives, different tolerances for risk, different demographic trends, different…pretty much everything.
So, no, I am not worried about the US turning into Japan, and I fully expect the markets to regain their sanity. This means a normalization of interest rates, at some point, at a level which is a better reflection of current levels of economic activity and inflation.
1.3%? Nope, I would rather take my money and grow it.
Take care, have a great weekend, and be sure to listen to our Trading Perspectives podcast.
John Norris
Chief Economist
As always, nothing in this newsletter should be considered or otherwise construed as an offer to buy or sell investment services or securities of any type. Any individual action you might take from reading this newsletter is at your own risk. My opinion, as those of our investment committee, are subject to change without notice. Finally, the opinions expressed herein are not necessarily those of the reset of the associates and/or shareholders of Oakworth Capital Bank or the official position of the company itself. Finally, we do NOT make a market in any of the companies listed in this newsletter, and I do not own them personally.