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A realistic comparison of Japan and the US shows US yields need to rise [ClearOnMoney]
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A realistic comparison of Japan and the US shows US yields need to rise

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Commentary

A realistic comparison of Japan and the US shows US yields need to rise

8 Sep 2011 by Jim Fickett.

When US and Japan bond yields are adjusted for inflation and compared over the respective property bubbles, it emerges that US yields have been, on average, lower, and need to rise.

Graphs that show US and Japanese bond yields both declining, after the respective property bubbles, are quite fashionable right now. The implication is that US Treasury yields will drop further still. Mebane Faber at World Beta has such a graph, and writes,

it is instructive to take a look a Japan and how their bonds have performed as we think that is one of the best comparisions. If you align the Japan series starting in 1990 and the US in 2000 you have a similar trend in interest rates. The interesting thing to note is that after initally crossing below 2% JGBs have not risen above that ceiling for the past 10 years.

Below is a version of the alarmist graph. The zero year on the graph represents 1991 for Japan, and 2005 for the US, the years of the respective property bubble peaks. (If you are going to claim a close parallel, these are the dates to align on.)

(US yields are from the Fed's H.15 report; see Japan government debt for sources on the Japan data. Click for larger image.)

It does catch one's eye that from mid-year-1 to year 5 the graphs match pretty well. But there is no match in earlier years. And does a similar trend in nominal rates for a few years really prove a close parallel between the US and Japan? Falling interest rates are common during periods of deleveraging, but this does not mean a closer parallel; most countries that experience deleveraging end up with inflation, not the deflation that Japan fell into.

The most important hole in the argument that the US bond market will follow the example of Japan is the difference in inflation environments. In the next graph, with an inflation adjustment, the parallel completely disappears.

For this graph, CPI (see US CPI & Japan inflation) is subtracted from the nominal bond yield to get one approximation for real yield. (Other approaches to inflation adjustment would be possible, but I am mainly interested here in the psychology of the bond market and, as shown earlier, bond buyers take into account only the inflation rate at the time of purchase.)

Besides the complete lack of any parallel in the inflation-adjusted graph, one other thing is notable. Japanese real yields have been, most of the time, above 2%, while US real yields have spent more time below 2%. In other words, if there is any real parallel between the US and Japan, it suggests that US real yields need to rise.

The current fashion of comparing the US and Japan bond markets is silly. As usual, however, there is still a chance that the silly argument just might lead to a good investment outcome. Mebane Faber, in particular, is at heart a trend follower, and the trend, right now, is belief in an incipient world recession. While recession fear grips the market, it would not be surprising to see US nominal bond yields go even lower.

I, on the other hand, am primarily a value investor. From the value perspective, the only way current Treasury bond yields make sense is if the US is really headed for deflation, and that is very unlikely. In a speech today, Martin Sullivan, former head of AIG, pointed out the very poor value proposition that current yields present for insurers:

Inflation may be a bigger risk for insurers than tsunamis or Europe’s sovereign debt crisis because claims costs could climb faster than the value of the firms’ investments, said Martin Sullivan, deputy chairman of broker Willis Group Holdings Plc. (WSH)

“Inflation could well be the monster under the bed,” Sullivan said today at an Insurance Insider conference in London, billed as his first public speech since he left as chief executive officer of American International Group Inc. (AIG) Rising prices “can be more deadly to an insurer’s economic health than defaults, earthquakes, winter storms, or tsunamis.”

Consumer prices in the U.S., China, Germany and the U.K. have advanced the most since 2008 this year, spurred by higher energy costs and government efforts to stimulate economies. Inflation adds to insurers’ costs for rebuilding property, treating injuries and paying legal claims that can emerge years after policies are sold, a problem that can be magnified by low interest rates, said Sullivan.

The yield on 10-year Treasuries is about 2 percent, compared with a U.S. inflation rate of 3.6 percent. The so- called real yield, or difference between the two, is negative 1.6 percentage points, the lowest since 2008. U.S. insurers hold more than $3 trillion in bonds to help back policies.

Of course markets can stray from rational valuation for a long time. The deflation story may capture imaginations for a while yet. QE3 could push yields down for a time. And if Europe crashes, the rush to “safety” will drive Treasury yields lower for a while. But not for 10 years. Buying a US 10-year Treasury bond with a 2% yield is nearly a guarantee of lost money. And that means that yields will correct.