With the Fed lowering interest rates to 0.25%, effectively zero, announcing further large purchases of agency debt and mortgage-backed securities, and announcing implementation of the Term Asset-Backed Securities Loan Facility to extend credit to households and small businesses, the Fed has embarked on a zero interest rate policy (ZIRP) and quantitative easing (QE). The U.S. is turning Japanese.
Merrill Lynch’s David Rosenberg wrote a piece back on November 28th entitled, "The new ‘D’ word: duration!," in which he commented on the Treasury market and expected actions by Bernanke based on previous speeches the Fed Chairman has made in the past. Sure enough, within a few weeks, Mr. Bernanke has indeed done what he suggested Japan should have done. A few excerpts from the piece are provided below.
This has a certain Japanese ring to it
Who was to know that the “release” of the information would take another five years? But keep in mind that Bernanke has already unveiled several of these measures, in terms of the discount window and excess bank reserves. But “increased purchase of longer-term government bonds by the Fed” has a certain Japanese ring to it and still leaves us moderately bullish on fixed-income, as a result.More aggressive actions the central bank can take
Speaking of Japan, Bernanke also delivered a speech on 31 May 2003, titled “Some Thoughts on Monetary Policy in Japan”. This was a seminal event, and if Bernanke practices what he preaches in this sermon, there are clearly more aggressive actions the central can take:
“Without denying the many difficulties inherent in making monetary policy in the current environment in Japan, I believe that not all the possible methods for easing monetary policy in Japan have been fully exploited. One possible approach to ending deflation in Japan would be greater cooperation, for a limited time, between the monetary and the fiscal authorities. Specifically, the Bank of Japan should consider increasing still further its purchases of government debt, preferably in explicit conjunction with a program of tax cuts or other fiscal stimulus.”…
Bernanke advocates fiscal plan financed by printing money
Once again, Bernanke advocates a fiscal plan that is financed by the Fed printing money. If it is good enough for Japan, you have to believe he thinks it is good for the USA.
"Under this plan, the BoJ’s balance sheet is protected by the bond conversion program, and the government’s concerns about its outstanding stock of debt are mitigated because increases in its debt are purchased by the BOJ rather than sold to the private sector. Moreover, consumers and businesses should be willing to spend rather than save the bulk of their tax cut: They have extra cash on hand, but–because the BOJ purchased government debt in the amount of the tax cut–no current or future debt service burden has been created to imply increased future taxes. Essentially, monetary and fiscal policies together have increased the nominal wealth of the household sector, which will increase nominal spending and hence prices. The health of the banking sector is irrelevant to this means of transmitting the expansionary effect of monetary policy, addressing the concern of BOJ officials about “broken” channels of monetary transmission."
There are several reasons why I believe we are going the route of Japan rather than the Great Depression II. Back in the Great Depression banks were allowed to fail and all of the excesses of the prior decade were wiped away in just a few short years, while Japan supported insolvent banks creating what came to be known as “Zombie Banks.” The Great Depression allowed all of the dead underbrush to be burned away by the deleveraging fire, while Japan quickly dumped massive amounts of water (Yen) on the fire and the dead underbrush was not removed. As a forest fire clears the way for healthy growth in future years by giving room for new trees and the strong trees that survived (solvent banks that were responsible) room to grow, trying to prevent forest fires keeps the unhealthy trees and dead underbrush able to compete for resources with the strong and healthy trees, weakening future growth. This can be seen below where after recovering from the Great Depression the economy saw growth rates ranging from 9-12%, with the subsequent expansion showing growth rates nearing 20%! With Japan, however, their economy has fluctuated between -3% and 4% for the past 12-15 years.
Figure 1
Source: BEA
Commenting on this subject is the famous investor Jim Rogers, with his comments provided below (emphasis added):
Jim Rogers calls most big U.S. banks "bankrupt" (12.11.08)
Jim Rogers, one of the world's most prominent international investors, on Thursday called most of the largest U.S. banks "totally bankrupt," and said government efforts to fix the sector are wrongheaded.
Speaking by teleconference at the Reuters Investment Outlook 2009 Summit, the co-founder with George Soros of the Quantum Fund, said the government's 0 billion rescue package for the sector doesn't address how banks manage their balance sheets, and instead rewards weaker lenders with new capital…
"Without giving specific names, most of the significant American banks, the larger banks, are bankrupt, totally bankrupt," said Rogers, who is now a private investor.
"What is outrageous economically and is outrageous morally is that normally in times like this, people who are competent and who saw it coming and who kept their powder dry go and take over the assets from the incompetent," he said. "What's happening this time is that the government is taking the assets from the competent people and giving them to the incompetent people and saying, now you can compete with the competent people. It is horrible economics..."
While not saying how long the U.S. economic recession will last, he said conditions could ultimately mirror those of Japan in the 1990s. "The way things are going, we're going to have a lost decade too, just like the 1970s," he said…
"Governments are making mistakes," he said. "They're saying to all the banks, you don't have to tell us your situation. You can continue to use your balance sheet that is phony.... All these guys are bankrupt, they're still worrying about their bonuses, they're still trying to pay their dividends, and the whole system is weakened."
In Times of 'Zombie Banks,' Buy Commodities: Jim Rogers (10.22.08)
Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke should resign for keeping alive "zombie banks" that should be allowed to fail, he said.
The Japanese government refused to let financial institutions fail in the 1990s, Rogers said.
"It's 18 years later and their stock market is 75 or 80 percent below what it was 18 years ago," he added.
Rogers also said that interest-rate cuts are coming.
"I know we are going to get aggressive rate cuts everywhere, that's why I'm long short-term government bonds in the U.S., but shorting long-term government bonds because it's not going to help, it's going to add to inflation," he said.
Besides failing to let the fire clear the dead brush in the U.S., there are also two factors that will contribute to prolonged sub-par growth in the U.S. for years to come. Like Japan over the last decade and one half, balance sheets will have to be restored as bank credit relative to GDP will be reverting back to its long-term average as the credit bubble continues to be unwound. As credit issuance slows in the years ahead we will see weak retail sales and corporate profits as U.S. consumers are forced to use savings rather than credit to fuel purchases. This process was cut short earlier in the decade as consumers were enticed to not hold off on future planned purchases in homes and autos as interest rates were slashed earlier in the decade on the fear of missing out on the financing bargains. In essence, pulling future sales to the present and creating pent-up demand. Things have changed with the consumer even more spent up with the Fed slashing rates to no avail, the so-called “pushing on a string” and the idiom, “You can lead a horse to water, but you can’t make it drink.” What you see below will mean revert no matter what the Fed and UST do, though their actions will determine the speed of the process.
Figure 2
Source: Federal Reserve/BEA
Another headwind facing the economy in addition to the deleveraging of consumer balance sheets is the unfavorable demographic trend ahead. (Note: Instead of rehashing the theory behind how demographics affect both economic growth and the stock market in this article, please see a previous WrapUp, Change We Can Believe In: The Slow Decline of the U.S. Consumer). Demographic trends are powerful forces that drive the overall secular trend in the economy and stock market. This can be seen in the figure below that shows how the Japanese stock market correlated with the country's demographic trend. Interestingly enough, the relative demographic peak in 1990 coincided with the end of the secular bull market in Japan and the trough in the demographic trend also corresponded with the end of the secular bear market. Future demographic projections point towards a secular bull market for Japan out to the end of the next decade.
Figure 3
Source: U.S. Census Bureau
This same trend is seen below in the U.S., with the relative demographic trend declining until 2015. This trend will lead to lower consumption rates for the next seven years, weighing on corporate profits and the consumption component of GDP.
Figure 4
Source: U.S. Census Bureau/Robert J. Shiller
Figure 5
Source: U.S. Census Bureau/BEA/ FRB Flow of Funds
Figure 6
Source: U.S. Census Bureau/BEA
With the two major headwinds of slowing credit growth and an unfavorable demographic trend facing the U.S. economy, sub-par economic growth and a continuation of the current secular bear market will dominate the years ahead. The U.S. is likely to mirror the Japanese experience, though probably to a lesser extent due to a more aggressive central bank and strong fiscal policy. It already appears the U.S. is indeed following the experience of Japan as our stock market (S&P 500) has followed closely with the path of the Japanese Nikkei 225 index. Real stock prices for both the S&P 500 and the Nikkei 225 have displayed uncanny resemblance as seen below, with the real S&P 500 from 1984-2008 overlaid with Nikkei 225 experience from 1974-2008.
Figure 7
Source: Bloomberg
The experience in Japan could very well play out in the U.S. as the rally Japan experienced from late 1998 to 2000 would correspond with a cyclical bull market beginning in the first half of 2009 through 2010. This coming cyclical bull market will be supported by a massive fiscal policy by the Obama administration and continued QE by the Fed as well as an oversold market. As the rest of the world begins to recover, foreign governments and investors will be diverting more of their assets towards strong emerging market growth as the case for emerging markets is not dead but simply taking a breather (and thus indirectly for commodities). Foreigners will also become increasingly concerned with the Fed’s balance sheet as well as record U.S. budget deficits for the next two years, which will likely weigh on the US dollar as the decade closes. By the Fed keeping long-term interest rates low through the purchase of buying U.S. Treasuries, the Fed will have to look the other way as the dollar weakens. A weaker USD will lead to higher import inflation and higher commodity prices. This renewed inflation threat may contribute to another recession down the road, which is likely why the Fed is considering issuing its own debt to help mop up the liquidity they’ve thrown at the system.
Figure 8
Source: Bloomberg (1989 Nikkei 225 peak shifted to 2000)
The 2014 to 2015 time frame for a potential end to the current secular bear market above using the Japanese example (shifted to correspond with the real stock price peak of 2000) fits perfectly with U.S. demographic trends, lending further support for the U.S. to likely follow Japan’s “lost decade.”
Figure 9
Source: BLS/Bloomberg (1989 Nikkei 225 peak shifted to 2000)
In the intermediate term, the stock markets are significantly oversold and due for a bounce. The Standard & Poor’s 500 Index is down 40.69% year-to-date after falling 53% from the high in October of 2007 to the low seen last month. The S&P 500 Index fell to nearly 40% from its 200 days moving average (MA) in November, which marked the second most oversold condition in the last 100 years. Clearly, the markets are oversold and due for a recovery bounce or at least some form of consolidation.
Figure 10
Source: Bloomberg
Figure 11
Source: Bloomberg
Figure 12
Source: Bloomberg
The 200 day MA often acts like a magnet where markets that move significantly away from the 200 day MA will tend to revert back towards it. This type of action was seen repeatedly during the Great Depression from 1929 through 1932. Whenever the S&P 500 was materially below its 200 day MA it tended to rally back up to it before resuming its bearish trend.
Figure 13
Source: Bloomberg
Figure 14
Source: Bloomberg
The current rally may have some legs left in it to push the markets back up to their November highs, but further downside action and consolidation are likely ahead before the bears head back to their caves. Support for further downside action comes from the FSO Financial Stress Index, which has greatly recovered from the lows seen in October, though still at the extreme levels seen in the last bear market. Clearly, the Fed and Treasury’s efforts are starting to pan out, but what is also clear is that they still have work to do to return normalcy and stability to the markets. We are getting closer to a bottom, though the time to deploy sidelined cash will be in 2009 as risk still remains elevated.
Figure 15
Source: Bloomberg
