• Edward Ballsdon

“Japanification” of the US Rates market now complete.




I suggested 6 years ago that there would be a “Japanification” of the Eurozone, whereby the European Government bond yield curves would converge to the Japanese one due to its’ debt and inflation dynamics. The government bond yields of Germany, France and other core Eurozone countries duly went negative, as they also did for the parts of the peripheral countries.


Breaking down the US swaps yield curve into its components suggests that Japanification is now priced in the US rates market. If that is correct, and the recent announced policies would attest to this, then the US is truly on the next stage of the credit cycle with far reaching implications for asset prices.


JAPANIFICATION


“Japanification” means many things to many people. My experience of the Japanese banking crisis as a credit loan officer in the early 90s leads me to break down the term into the Cause of “Japanification” and the “Effect” from it. Put simply:

  • Cause: Over indebtedness

  • Effect: Incapacitated banking system (low lending rates, evergreening), anaemic growth, low inflation, low interest rates etc.


There are many different ways to assess the “over indebtedness”, whilst the size and timing of the effects are a function of fiscal and monetary policy.


JAPANIFICATION OF THE EUROZONE:


A state of overindebtedness can be seen to exist by looking at Debt/GDP ratios for different Government, Corporate, Household sectors in different European countries. The lack of fiscal and limited monetary responses have resulted in poor European growth and persistent disinflation. Given the ECB’s mandate, rates have been cut and have remained very low.


The chart shows the difference between the European and Japanese 1 year interest rate swap in 5 years, that is to say the market’s expectations for the interest rate differential between the two countries in 5 years’ time. Until 2011, the market thought this difference in forward rates would be more than 2%, but following the peripheral crisis in that year, European interest rates declined to Japanese ones, converging in 2015 when European HICP inflation hit 0%. After a brief rebound, both 5y1y Eur and JYP interest rates are once again identical (at ~ 0%). Put simply, both the European and Japanese markets expect that interest rates will be at 0% in 5 years’ time.



The Japanification of Europe seemed like a big deal 6 years ago - it is now mainstream thinking. The market is now used to a weak European banking system that is consistently valued at cheaper levels to US banks, weak economic growth and low inflation. It is understandably therefore that the market expects low interest rates for a long time (the 1y rate in 30years is -0.1%!). The market’s focus in now on the diverging debt profiles of different countries in the Eurozone (North vs South) and the survival of the Eurozone as a currency block.


US vs EUR Forward Rates?


The chart below demonstrates the 5y1y forward rate in the US (Red), and its’ decline in the recent financial market turmoil. It also depicts the 5y1y European rate (Blue), and the convergence of the US to the Eur rate (Spread in black). Key highlights from the chart:

  • When the spread went negative (i.e. US forward rates went below European ones) during the GFC, forward interest rate expectations were still relatively much higher compared to today’s levels - Japanification was not expected for either the US or Eurozone.

  • The decline in EUR forward rates from 2013 was matched by a decline in USD rates, but not to the same extent – the spread widened and remained wide until only recently.

  • Following the recent Covid19 pandemic market moves, the spread has markedly reduced.

  • Does this now mean that Japanification of the US is now priced in to interest rate markets?



JAPANIFICATION OF THE USA?


A NOMINAL swap rate can be broken into two components (Nominal = Inflation + Real Yield).


  1. The expected INFLATION (breakeven) rate. If inflation is expected to rise, then the inflation component will rise and vice versa if it is expected to fall. There will be a mathematical outcome that cannot be manipulated by central banks (QE etc).

  2. The REAL YIELD. This shows how much a swap will yield after inflation. This is derived from a combination of expected economic growth and future monetary policy, and is a function of supply and demand.

The left chart below shows that the decline in European NOMINAL forward interest rates (Black) was led by a collapse in REAL YIELDS (Blue), which have been negative since 2014, and more recently by a collapse in forward INFLATION expectations (Red). In the US, REAL YIELDS remained above 0% until June19 and in the recent market turmoil have declined substantially (currently 5y1y stands at -0.72%). INFLATION breakevens also declined but have subsequently bounced back.



Charts below combine the above two charts, depicting the longer (left) and shorter (right) historical differences between US and EU forward NOMINAL, INFLATION and REAL YIELDS. The recent decline in the spread between NOMINAL yields is almost entirely due to the reduction and convergence in the REAL YIELD spread (now 3bp). Whilst the same happened before in the GFC, NOMINAL rates at that time were still very elevated.


The difference between Nominal forward yields is currently 90bp, 87bp of which is due to the difference in forward inflation yields, which would lead to a conclusion that there remain different inflation expectations. BUT there is a big difference in the way US CPI and EUR HICP inflation indices are calculated, with the US CPI having “Shelter” representing 34% of the index compared to ~7% in the European HICP index. Calculating the two inflation rates with the same weighting would reduce the US Core CPI inflation rate by ~ 0.6%, which would almost elimate the 0.87% inflation differential in inflation swaps (Hat tip Albert!).

CONCLUSION


Forward US Interest Rates price the Japanification of the US because 1) US forward real yields have converged to European ones at very low absolute levels (@ 0%) and at very low forward nominal levels. Furthermore, once different inflation calculation methodologies are accounted for, forward inflation swap also price in Japanification of US inflation.

IMPACT ON ASSET MARKETS


If the US has really reached the Japanification stage of its economy, as interest rate markets price and the debt data would suggest, then this would be confirmation that the US is moving to the next stage of the long term credit cycle. This is where the private sector deleverages (as a %GDP), despite 0% interest rates and in defiance of mainstream economic rules found in textbooks (as an aside, the US Household sector has been deleveraging to GDP ever since the GFC). The public sector is thus forced to intervene through fiscal policy and take up the slack, just like Japan had to.



In the last 10 years Monetary Financing was let out of the bag with QE which proved everything but “Temporary” in nature. This next phase should see Central Banks finance that extra fiscal policy – this is straight out of historical textbooks, the Japan experience, and classic EM policy when they hit crisis, and just what the FED is doing with its’ unlimited balance sheet monetary policy.


Impact on financial assets


1) Interest Rate Curves should in the short term remain low and flat as Real Yields remain low and inflation expectations remain depressed (see below). Back ends of the curves should invert due to the stresses of Pension and Life Insurance company balance sheets (note the recent move in UK 10s 50s). The Japanese flip of the correlation of curve to yield in June19 has remained in place – the same happened in Europe in 2011 and Japan in 1995. Bull flattening/Bear steepening is the new norm.

2) Currencies will be debased according to how much debt is issued in relation to current account balances. Japan managed to substantially increase its’ fiscal deficits because it ran a current account surplus and had no debt in foreign currencies.

3) Equity Valuations can surely only return to previous multiples if there is an increase in private sector leverage, or Central banks buy equity or Central Banks increase their balance sheets by more than the increase in Federal debt. Because there are important questions about bailout terms and conditions for both companies and banks (who will indirectly benefit from aid that will limit the growth in NPLs) it is hard to assess what the equity multiples will be post the Covid19 economic recovery. Have Japanese corporates, with their large cash hoardings post their own debt bubble, given an important clue of how US and European corporates might behave in the future, which would limit future equity valuations.

4) Gold and precious metals should be the big beneficiary of a large expansion in global monetary bases. I will leave the numerous goldbugs to sell this story.

Inflation Expectations

I have already posted on why Consumer Price Inflation will most probably remain low and decline in the short term, pointing out the difference between Consumer Price and Asset Price Inflation. There are two serious issues that are about to strike inflation:


A) OIL PRICES. The recent decline in oil Prices will have a large negative effect on headline inflation rates around the world. Below left shows the historical annual change in oil prices and the annual change in the Energy component in the US CPI basket, which has a 8.1% weighting of that basket. The right chart is that Energy component again, and the Headline CPI rate, depicting how the latter is impacted by the former. There is clearly about to be a large decrease in headline inflation due to recent oil declines.


The following charts show the same will happen to European (left) Japanese and UK Energy and thus their headline inflation rates.



B) SHELTER AND HOUSING. Shelter represents 33% of the US CPI basket of Goods and Services, whilst Housing represents 27% of the UK inflation basket. Both are included in their respective CORE inflation rates and are very sensitive to the economic downturns. Note how in the GFC both the inflation rates of these basket sub components went negative, dragging down core inflation rates (the core UK RPI went deeply negative).


The negative Oil and Shelter/Housing effects should combine to bring a large reduction in headline and core inflation rates in the near term. This is somewhat priced into the very front end of the Eur and US inflation curve – but not for the UK curve. That looks like a complete mispricing! What happens to long end inflation expectations is a completely different story and worthy of a separate post!



A final and perhaps amusing comment comes on inflation and market surprises. The chart below shows the year on year change in oil against the Citi Inflation Surprise indices. These calculate the difference between the inflation data and economic forecasts for that very data. A negative reading suggests that released inflation data was weaker than expected and vice versa. The chart suggests that the market is surprised by the oil impact on inflation rates. If that holds true, the next few months will bring some very large surprises!