A Broken Bond - II

Sep 24, 2016

The bond market today is in uncharted territory. They're the target of central bank quantitative easing and are today at record highs. By some estimates, US$13 trillion worth of bonds have negative yields. The yield on ten-year treasuries is lower than the dividend yield on the S&P 500.

The bond market of Japan remains the most curious. Bond yields in Japan have been low for a long time, but now they've turned negative. And the BoJ governor recently announced a cap on 10-year bond yields.

Japan has been a great case study for various stages of economic growth. The fast rise of japan in the late twentieth century is a template for catch-up growth. Today, however, the stagnant and debt-laden economy could be a case study of a completely different kind.

What is a liquidity trap?

A liquidity trap is a situation where monetary policy becomes ineffective. Lowering interest rates usually results in increased private investment. But the effect has diminishing returns. An economy enters a liquidity trap when interest rates are already very low and further decreases do not have a positive impact on the economy. Japan is an acute case. Interest rates there have been below 2% since 1998. Why haven't these low interest rates increased private investment?

The private sector has preferred to hoard cash. Net business debt has been falling. And by some estimates, the cash held by Japanese firms has reached $2 trillion. The lack of investment can be attributed to private deleveraging. After the crisis in 1989, the private sector paid down debt. While the debt position has improved, the private sector has not started investing in the Japanese economy. Primarily because demand in the economy is almost impossible to gauge.

The 80's were characterized by build of corporate debt and a bubble in the real estate sector. This mal-investment in the system has not been fully purged. Private sector debt has been replaced by public debt. This means the demand in the economy is dependent on continued deficits and more public debt. In this scenario of uncertain demand, the corporates are rightly cautious about domestic investments. Japanese companies are looking for investments abroad.

Academic theory suggests two ways out of a liquidity trap. The first is to build 'bridges to nowhere', or provide 'fiscal stimulus' as the academics prefer to call it. The idea is that the liquidity created by the central banks is not reaching the economy. Nobody wants to borrow and invest because the demand situation is so unclear. So, the argument goes, the government has to engage in public works and fixed investment. This means more roads, railways, and bridges - even if they're unnecessary.

The second remedy is what the academics call 'unconventional monetary policy' and what I call 'Peter Pan's Flight'.

BoJ Governor Kuroda once told an audience, 'I trust that many of you are familiar with the story of Peter Pan, in which it says, "The moment you doubt whether you can fly, you cease forever to be able to do it."' He was referring to the current crisis of confidence. His comments are meant to assure investors that the BoJ is committed to stoking inflation. The bank intends to overshoot its inflation target. A sign of rising inflation will not result in a subsequent rate hikes (which is the common practice).It means holding the rates low in the face of inflation to ensure negative interest rates. Will this help galvanize demand and investment?

Paul Krugman, in his 1998 paper, Japan's Trap, refers to this as 'unconventional monetary policy'. It talks about central banks establishing credibility that they will be 'irresponsible' and overshoot their inflation targets.

Japan has been a great experiment for the world. Its economy - with its indebted government, deleveraging private sector, demographic challenges, low rates, and no inflation - is leading the way for the rest of the developed world. Will 'Peter Pan's Flight' work? How long will Japan believe it can fly? The world is watching.

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