I don’t understand the Japanese economy. The federal government has a huge debt burden, and the country’s bonds have suffered credit rating downgrades, yet the yield on the 10-year bond is less than 1%. I asked a well-recognized global economist for a huge US bank to help me understand this seeming paradox. He suggested that Japanese rates would be substantially lower without the downgrade and the country’s ultra-loose monetary policy. While I guess that makes sense academically, I continue to wonder. I mean, how much lower could yields really go from here?
Japan comes to mind as Federal Reserve Chairman Ben Bernanke, in a recent letter to Congress, indicated a willingness to pursue additional Quantitative Easing (QE3) and purchase what some suggest may be an additional $750 billion of government-backed mortgage bonds. At present, the simple reinvestment of maturing holdings will provide about $200 billion in new purchases this year. Since 2009, the Fed has purchased $1.25 trillion in mortgage backed securities which may have stemmed the bleeding but not healed the wound. Between the housing price peak in 2006 and the first round of Fed purchases in 2009, prices fell about 28%. Since 2009 they have declined an additional 4% for a total drop of 32%. And the price decline may not be over.
We have long argued that residential real estate is of lynchpin importance to the US economy and its recovery. The ongoing bursting of the housing bubble has been the first punch of a classic one-two combo that led to a banking collapse uppercut. Housing represents a meaningful portion of GDP and, other than her job, is the largest asset most Americans have. As the value of one’s largest asset declines, confidence is undermined and a source of savings is impaired. In a consumer-driven economy, this blow to the ability and willingness to spend is crucial.
To many, Japan’s economic policy has failed because its economy remains at stall-speed. Yet it may be that Japan would be in a far worse condition had it not taken the steps it has. In the US, many suggest that the Fed’s Quantitative Easing has failed and are perplexed as to why they would consider pursuing such failed policy.
BUT, it may be that Quantitative Easing and the huge mortgage-backed bond purchases have saved us from a far worse fate. While the jury deliberates, we think that the current housing recovery is critical and very fragile. According to Bloomberg, “While the Fed has helped push mortgage rates to record lows of less than 4%, home-loan borrowing in 2012 is forecast to decline to the least in 15 years.” The supply of credit and the demand for housing remain well below the levels needed to clear the existing housing supply and return the housing market to a healthy state.
Richmond Fed President Jeffrey Lacker appeared on CNBC’s Squawk Box with Steve Liesman this morning and said that “The Fed doesn’t control growth.” I agree, and I also believe that the markets have become far too preoccupied with the Fed’s next move. The Fed has played a very important role in stabilizing our economy and financial systems, and it continues to do so today. However, the economy and markets will only return to a healthy state when investors shift focus from anticipating government’s next move to anticipating organic improvement in corporate earnings.
As a final note, The Arrogance Cycle is now available on audio through Amazon. The great Bruce Horlick does an amazing job of making my words come alive. If you prefer to listen to business books, I think you will find that Bruce is able to capture, inform, and entertain listeners like few can.