U.S. Rates Chart a Course in Japanese History

Analogies are not deterministic, and it is important to note the very major differences between the U.S. and Japan, not the least of which has been the solvent U.S. banking system and an American reliance on capital markets, not banks, for corporate financing.

The U.S. has skirted deflation for now, and the American economy has been growing, two other conditions absent for extended periods in postbubble Japan. Japanese policymakers erred by raising taxes in 1997, while marginal U.S. rates have been reduced before any application of the Alternative Minimum Tax. And yet for all of these key differences, the parallel courses of postbubble interest rates demand examination.

A Walk Down Memory Lane

We not only can compare U.S. rates with Japanese rates, we can look at U.S. history as well. The Federal Reserve's long-term histories of selected interest rates for corporate bonds, long-dated Treasuries (10-year only after June 2000) and Treasury bills provide no indication that we are at a natural floor in interest rates.

The last time three-month bills were at present levels, November 1954, long-dated notes were yielding 2.57%, and high-grade corporates were yielding 2.89%.

Selected Monthly Interest Rates

Source: Federal Reserve

Even more instructive than ordinal levels are the spreads between corporates, long-dated Treasuries and bills. Each time the spreads widened out to recent levels and contracted -- a phase we have been in over the past year -- bond yields have fallen.

Spreads to Treasury Bill

Source: Federal Reserve

An interesting question, one involving the role of free will in macroeconomic decisions, is whether the recent course of interest rate movements creates conditions in which future events, accidents if you will, will produce a foreordained outcome. We have seen how a monetary policy designed to prevent deflation has succeeded in this task, but as a natural consequence has led to a weaker dollar and a reflation of assets such as real estate and bonds that respond predictably to lower costs of carry. In addition, a fiscal policy designed to stimulate the economy and to engage, rightly or wrongly, in global military activities has exacerbated a national debt load prior to the impending retirement of the baby boom generation.

How hard is it at this point to envision a scenario in which trigger events, such as a banking crisis in China, further terrorism and responses thereto, or even a mistimed tax increase in the next administration, Bush or Kerry, will lead to a recessionary or deflationary shock? If any of these events play out, the interest rate analogy to Japan may very well continue.

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