Is deflation that bad?
For bond market investors the call between deflation and inflation is an important one. As a general point, deflation favours creditors as it tends to boost real ex-ante returns, while inflation favours debtors as it reduces the real value of future liabilities. Recent events in Japan could mark a shift between one regime and the other. What we know is that Japan has been experiencing deflation for a number of years and that this has had a major influence on the development of the yen bond market. If the recent shift in monetary policy in Japan is to be permanent then it may be the case that Japan will prove to be a roadmap for what a deflation regime can do to bonds and what an inflation regime can do to bonds.
Europe should take note. The way things are going, Europe is heading towards deflation as de-leveraging and fiscal tightening continues to dominate the macroeconomic outlook. The question for holders of European bonds is whether deflation will prove to be a positive influence on returns or whether it will mark the death-knell of monetary union.
Lower prices, lower yields, happy investors
Japan has suffered deflation for a long time now. The consumer price index peaked in 1998 and since then, according to the Monthly Consumer Confidence survey, there have been various, quite prolonged, periods where inflationary expectations have been negative. This entrenched deflation has had a profound effect on bond markets. Because of Japan’s high domestic savings surplus and current account deficit, not to mention its demographic structure and the appetite for risk that goes with it, deflation has meant that domestic investors have been willing to continue to buy low nominal yielding Japanese government bonds.
In turn this has allowed the government to fund a very large budget deficit over a number of years and avoid the fiscal catastrophe that many people have forecast. Yields reached a high of 7.8% (10-year JGBs) in October 1990, about a year after the peak in the stock market. At the end of March this year, just before Kuroda announced the Bank of Japan’s new QE programme, the 10-year yield had fallen to 0.5%. Moreover, since 1997 the yield has been below 2%. This is the level of inflation that the new policy regime is targeting and it is also the level below which yields in the core developed markets of the US and Europe have recently fallen below. Despite low yields for a long time, total returns from holding Japanese government bonds have been quite good.
A domestic affair
Over the past 10 years the compound annual nominal return from a JGB index has been 2.3%. Over the same period inflation has average -0.3% per year, so the real return has been 2.6%. No wonder Japanese investors have been willing to finance their government’s borrowing requirements. Unlike the trend in many other bond markets, Japan’s is dominated by domestic holders, with foreign investors holding less than 10% of the JGB market (according to Normura research). Over the same period the duration of the market has also increased as the government has issued longer maturity bonds. Indeed, having an ageing domestic investor base happy with capital preservation has allowed the Japanese government with the opportunity to extend its liabilities, giving the political elite more time to come up with a solution to the rising real value of what are inter-generational costs.
No credit boom in Japan
Another notable development has been on the corporate bond side. As I note above, deflation is actually negative for borrowers. While the government has the ability to extend its liabilities, this is not so easy in the private sector. Corporates in Japan have been de-leveraging for a long time and this has led to a reduction in not only the relative size of the corporate bond market relative to government bonds but to an actual absolute decline in the value of the market and the number of corporate bonds in issuance. Why would a corporate borrow in an environment of declining nominal revenue growth which would increase the value of its future debt repayments in real terms?
Moreover, with deflation at the macro level the incentives for companies to invest in capacity have also been absent. As such the corporate debt market has shrunk and corporate credit spreads have narrowed even more than has been the case in the US and Europe.
The wrong kind of deflation – Before considering what might happen in Japan now, it is worth considering some of these trends and how they might apply to Europe. European core bond yields have fallen below 2% over the last year and inflation is on a downward track.
Growth is weak, fiscal policy is restrictive, monetary policy too tight, the currency too strong and the economy has major structural rigidities. Deflation for Europe is a real threat. Could Europe experience a similar benign deflation as Japan? Deflation will boost real returns to bond holders even as nominal bond yields are low and that could mean that deficits, which are unlikely to fall rapidly in a weak nominal growth environment, could be financed by domestic investors. Corporate and financial indebtedness would continue to fall and credit spreads would shrink, boosting returns to holders of corporate bonds.
Sounds too good to be true? Probably because it is. Europe is different from Japan in that it is a fragmented bond market in a single currency area. The candidates that come near to the Japanese model of high domestic savings and social cohesion are few and far between – perhaps Germany and possibly Italy. For those, like Spain, that have a reliance on external funding deflation is not really an option. A feature of the Euro crisis has been the repatriation of cross border investments within the Euro zone, which has exposed those borrowers that do not have sufficient savings to finance their own budget deficits. In the height of the crisis the most vulnerable had to be bailed out by official external financing. Since then, the other potential vulnerable ones have just about hung in as a result of the combination of domestic fiscal control and the promise of either future external official bailouts or an ECB monetary policy regime shift.
Negative fiscal dynamics – the markets understand the need for credit risk premiums in European sovereign debt. If deflation kicks in without a decline in these premiums then the debt dynamics get worse. Spain is paying 3%-4% to borrow – which is more than its current inflation rate, and inflation is likely to fall further as the economy contracts. Italy’s inflation rate is 1.8% and falling yet its bond yields are 3%-4%. The combination of missed fiscal targets and upward revisions to debt projections will just make things worse.
Captain Kuroda…
Deflation only works if the domestic pool of savings is large enough and compliant enough to fund a government and that government then has the luxury of time to get its fiscal house in order. And remember, deflation is not good for fiscal stability as the real cost of debt keeps rising. Japan has finally woken up to the fact that it couldn’t just go on like that for ever.
Few countries in Europe have the luxury of time to get their fiscal messes cleared up. So Japan is now going for massive reflation with plans for the Bank of Japan to buy around 1.6 times the amount of Japanese government bonds that are likely to be issued in the next couple of years. It wants to generate inflation of 2%. For investors in low nominal yielding bonds this is a disaster as real expected returns will collapse.
The market has already responded by selling JGBs and generating a lot of noise around potential Japanese investors switching into other bond markets. If inflationary expectations rise, JGB yields will rise; if the real economy responds, companies will start borrowing again and credit spreads will widen. Inflation benefits the borrower not the creditor.
…disappointing Draghi
It’s hard to reason against Europe needing to follow the Japanese example. It is not the German solution because Germany does not like policies that reward the debtor nor does it like inflation that hurts the saver. But Fed/BoJ style QE would provide the debt relief that is needed in some parts of the Euro Area and generate the decline in real yields that has so far been absent. However, we shouldn’t hold our breath. The muddle through approach is the consensus one and Europe will continue to rely on taking problem countries into financing programmes that trade off tough fiscal conditionality for ECB intervention to keep sovereign financing going.
It is not clear that this provides a real solution. At the moment negotiations are taking place that will likely extend the maturity of the loans that have been extended to Ireland and Portugal., Greece is likely to need further debt relief at some point and Official Sector Involvement in debt relief seems to be the preferred longer term solution (which is a burden on Euro Area tax payers as a whole). Without QE and with the conditions for Japanese style benign deflation absent, debt relief has to play a continuing role in reducing longer term debt/GDP ratios in Europe.
The hope of the muddle through working has to also partly rely on the perpetuation of the belief that Private Sector Involvement (PSI) in debt relief will not happen again. To me this is nonsense. If that is true then investors should buy lots of Italian and Spanish debt because they would never get haircut and all that would happen is that eventually the official sector would buy up their debt and then restructure it. It cannot be right that private sector investors don’t share in the burden of any future sovereign debt restructuring. Actually, the market doesn’t really buy it either otherwise Italian and Spanish spreads would already be much lower.
