U.S. Rates Chart a Course in Japanese History

In this business, when someone asks whether you believe them or your lying eyes, the best course of action is to go with your lying eyes. The renewed downturn in interest rates, especially at the longer end of the yield curve, is forcing us to decide between our own judgments or those of the market. (You may fill in your own ragged Wall Street cliche at this point.)

The Japanese experience with the 1980s bubble and its subsequent collapse holds an eerie and even morbid fascination for American analysts; witness the numerous discussions as to whether the Nasdaq has remained on a course parallel to the Nikkei following its bubble peak. Often ignored in these stock market comparisons is an equally compelling analogy, one I made back in October 2002, between Japanese and U.S. interest rates.

While the federal funds rate and the discount rate get all of the ink, these rates are of direct importance only to banks. Businesses and individuals would be hard-pressed to borrow and lend at these rates. A six-month Libor rate for both the dollar and the yen is a better instrument of comparison; the six-month horizon is more reflective of both market expectations and actual cash management decisions and is far less noisy than the three-month rate.

A Tale of Two Rates

Source: Bloomberg

Six-month euroyen rates rose for a year after the December 1989 peak of the Nikkei. In contrast, six-month eurodollar rates started falling by September 2000, and taken as a percentage of the stock market peak levels, fell further and faster than did euroyen rates. At this point in time, eurodollar rates have leveled off, as euroyen rates appeared to have done in 1995. A casual glance at the course of euroyen rates after that point belies the argument that eurodollar rates cannot go lower from here.

The longer end of the curve tells a somewhat similar story. Once again, rates on U.S. 10-year notes rose less after the respective stock market peaks and fell both further and faster as a percentage of the peak levels. While the paths were not as parallel up until three years after the stock market peaks, it is interesting to note that last June's nadir in yields occurred in the 169th week after the stock market peak. Japanese 10-year yields hit a similar nadir in February 1993, 166 weeks after the Nikkei's peak. The present bond rally is occurring right on schedule; this is December 1993 based on the Japanese analog.

If we follow the Japanese path -- and I am by no means offering this as a forecast -- we could see a spectacular selloff in bonds in the near future, followed by a long and enduring descent to yields now unimaginable.

Markets can make the unimaginable real: A convention of those who forecast in March 2000 that we would now be in our ninth month of a 1% federal funds rate with no end in sight could be held in a very small room. Neither I nor anyone I know would need to attend.

Ten Years After

Source: Bloomberg