“Change is not only likely, it’s inevitable.” – Barbara Sher
Most investors, economists, and pundits believe that interest rates here in the US have nowhere to go but up. The conviction in this belief is so strong that many would consider it an inevitability. Some industries, primarily those tied to lending money, are using the high conviction of this widely held belief to push their products under the guise that the opportunity for low interest rates is fleeting. The consensus on Wall Street coming into this year was that the interest rate on the 10-year US Treasury Note would be at 3.4% by the end of the year versus the 3.0% level the note carried at the start of the year. Unfortunately for some, say those that make their living predicting the direction of interest rates, it has not played out as expected and rates have dropped all the way down to 2.33% two weeks ago and currently stand at 2.50% today.
The drop in interest rates and rally in bond prices have left many scratching their heads. It is easy to look at historically low interest rates and come to the conclusion that they must go up. This change is inevitable, either through economic recovery/normalization or a catastrophic default, but no one knows exactly when the reversion to the mean will start and how long the process will take. One glaring example is the nation of Japan, which has been dealing with a Balance Sheet Recession since their debt bubble burst back in the early 90’s. Although the Japanese have a much different culture than the United States, their present circumstances could very well be the rest of the world’s future.
Japan went through a euphoric credit expansion that drove debt levels and assets tied to lending (e.g. real estate) to nose bleed levels through the 1980’s and into the early 90’s. In an effort to curb the rapid expansion of credit and inflation, the Bank of Japan rose interest rates which ended up bursting the debt bubble and sending the economy into a violent recession. The unwinding of the massive debt bubble meant individuals and corporations were left with huge debt burdens while the asset side of their balance sheet continued to decline as assets were liquidated to meet debt obligations. The continual deleveraging by individuals and companies was deflationary leading to two (and counting) “lost decades” of economic production and growth. Deflation and risk aversion has led to a whole slew of economic problems including stagnant wages, a shift to part-time versus full-time employment, and a general absence of “animal spirits.” Try as they may, the Bank of Japan has not been able to break the deflationary cycle, which is why the yield on their 10-year debt currently trades at historically record lows of 0.5% even though the BOJ has committed to a 2% inflation target with a very aggressive QE program. Japan has shown that once animal spirits are broken, they are very difficult to repair.
One advantage the US and the rest of the world had in dealing with our most recent financial crisis is the fact that Japan was a great case study on how not to handle the problem. This was one of the reasons why the Federal Reserve has been so aggressive in staving off deflation by embarking on numerous monetary stimulus campaigns. The question is whether the comparatively early use of the QE bazooka by the Federal Reserve will be enough to avoid the path laid out by Japan with two (or more) lost decades of stagnant wages and sub-par growth.
The problem with QE and other forms of monetary stimulus is that they are very hard if not impossible to exit. Once the market becomes accustomed to QE, the expectation becomes that QE will continue indefinitely. The only justification one could have for buying Japanese government bonds at 0.5% yield is that the BOJ will continue buying the bonds to keep interest rates low in an attempt to stimulate the economy. Any deviation from this glide path is difficult for the market to digest as we saw last summer during the Taper Tantrum here in the US. The increased volatility and rising interest rates associated with the withdrawal of monetary stimulus might rock the boat too violently and stunt the fragile economic recovery the Fed has worked so hard to engineer. As such, central banks around the world find themselves stuck between a rock and a hard place while public sector debt levels continue to grow as tax receipts (income) trail spending due to weak GDP growth. Eventually, the debt burden becomes so large that central banks are forced to keep interest rates artificially low so that governments can continue servicing their existing debt. This is the corner Japan has painted themselves into with a debt-to-GDP ratio north of 225% and a 10-year interest rate hovering around 0.5%. Maybe the US and other developed countries will avoid Japan’s fate, but if not, then a dramatic, near-term rise in interest rates may not be as inevitable as many believe.
Author Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.
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