US policy makers are finding out the hard way that what happens overseas sometimes matters more to the government bond market than what happens at home.
Unbeknownst to me at the time, I learned a valuable lesson at the start of my career that would resurface years later. Nearly 16 years ago, I began working in Tokyo as an analyst on the Japanese government bond (JGB) trading desk at Morgan Stanley. It was August, 2000, and the Bank of Japan raised its overnight policy rate by 25 basis points for the first time since initiating its zero interest rate policy, in February 1999. That same month, 10-year JGB yields rose by a similar quarter percentage point.
Over the next several months, however, I learned that what happens overseas sometimes matters more to the bond market and to the central bank than what happens at home. After that initial 25-basis-point increase, 10-year JGB yields proceeded to decline rather precipitously, by 100 basis points, over the next seven months. The move to lower yields ended, temporarily, with the BoJ reversing course on its policy rate. The dot-com bubble had popped and equity markets began a multiyear decline.
Similar to the BoJ back then, the Federal Reserve now finds itself subject to forces and events overseas. The outcome of the Federal Open Market Committee’s March meeting, with the median participant removing two rate hikes in 2016 and Fed Chair Janet Yellen’s subsequent speech—both referencing risks posed by global economic and financial developments—were much more dovish than the market had expected. Presciently, our US economists had also removed two rate hikes from their 2016 outlook earlier that month. Their views on US growth and inflation are well below consensus—prompting us to deliver well-below-consensus Treasury yield forecasts.
We see 10-year Treasury yields ending 2016 at 1.75%, near current levels. But we see even lower yields catching investors off guard in the middle quarters of the year. The lessons I learned in Japan leave me comfortable with this outlook. Years of staring at low JGB yields certainly immunized me from the sticker shock associated with low Treasury yields. And I know that investors tried to short JGBs, mostly without success, for years.
It wasn’t until I read Richard Koo’s tome, The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession (published in 2008), that I began to understand why yields got and remained so low. The book changed the way I viewed the world and the way I interpret the message from government bond markets. Koo, who is chief economist at the Nomura Research Institute, laid out the concept of a balance-sheet recession so clearly that anyone with such an understanding ex ante would have never dared short the JGB market.
The idea that credit demand could become inelastic with respect to price struck me as novel. That the price of credit, even government credit, could fall without a commensurate increase in demand perfectly explained the way the JGB market evolved during Japan’s lost decades.
The idea also explains the way global sovereign bond markets have evolved since the world emerged from the Great Financial Crisis. As our economists have suggested before, the world is dealing with demand deficiency. The decline in government bond yields globally suggests simply that the deficiency is growing. If the private sector isn’t willing or able to borrow and spend enough to generate a sustainable inflation impulse, despite the increasingly lower costs to do so, then the public sector should step in to prevent deflation.
Ultimately, that is the message from government bond markets today. The public sector, to the extent that it can control its own money supply, needs to borrow and spend because the private sector isn’t spending enough. The situation has gotten so extreme that investors are willing to pay certain governments to do just that. In Japan, with a negative yield on 10-year JGBs, investors are paying the government to borrow out to a 10-year term and spend.
If the public sector ignores these types of messages on a global scale and private demand globally remains deficient, those same investors will accept still lower yields on government bonds outside of Japan—our base case for the rest of 2016.