Friday, May 25, 2012

Can U.S. Interest Rates Drop Much Further? With Comments on Implications If They Do

Yes, they can.  My lodestars in this regard are two-fold.  One is Japan's experience with ZIRP.  Japan first ZIRPed in 1999.  In 2003, their 10-year yield collapsed as low as 0.5%.  We are now in our fourth year of ZIRP.  Respecting the charts kept me in the NAZ bubble into Y2K.  Respecting the charts is keeping me long bonds.  It worked in Japan, it's working here.  (But I'm not betting the farm on it.)

The second lodestar is Germany in the here and now.  I take the POV that Germany is a defanged country.  On the most major issues, it does what it's told (and that's a good thing).  But there's only country that can pull rank on Germany, and that's the U.S.   So one way or another, I take what I think is a realpolitik POV and say that if investors can bid German 10-year yields down to yet another record today of 1.37%, the U.S. can sustain those yields as well.

No one said it's logical.  No one said that when the NAZ hit (say) 2500 in 1999, that that was fair valuation.  It was insanely high.  But it doubled in about a year, and went a tad higher than a double.
That, BTW, was Japan's experience.  Here's an interesting link to a history of Japan's interest rates covering most of its ZIRP era.  Lots of volatility.  The same could happen here.

Putting it in my favored analogy, I think of ZIRP as a fisherman hauling in a fish that has taken the hook but good.  The fish is doomed, but from time to time the fisherman lets it run to exhaust itself.  The fish in this analogy is the 10-year, the boat where the fisherman is stationed is the zero interest rate bound.  That's sort of how it's been in Japan and sort of how it's been here.  Wild and crazy stuff, with the only other precedent "sort of" being the U.S. post-Great Depression period.

One way or another, the continuous nature of ZIRP makes any positive yield better than nothing year after year.  As investors despair of ZIRP ever ending, they go through Kubler-Ross stages of anger toward acceptance and give in to lower and lower rates as better than nothing.

Of course, rational expectations keep investors from wanting to accept that ZIRP historically is something like the quicksand or flypaper it has been in Japan.  Dr. Bernanke apparently has a whole thought construct of how ZIRP can be permanent, or nearly so.  Can this really happen?  Well, he's only the most important banker in the world.  Think what you will of his policies, he is Dr. Big.  So I give his thoughts deep consideration.

I would add that semi-permanent ZIRP almost guarantees poor stock market returns in the aggregate.
The best Japanese stocks since its bubble collapsed have been those that competed internationally.  It's something I always keep in mind now, given the major differences between Japan and the United States.  As I discussed in a post or two around September/October last year, I went to a U.S.-centric investment posture around then, focusing on muni bonds given their high yield relative to Treasuries.  That was a good decision, but it's looking played out for new money (though I like the NIOs of the world - for now).

If the stock market takes a major tumble in the months ahead (I am not expecting a crash imminently and perhaps not at all), I want to think long and hard about whether the Japanese stock paradigm will be operative for U.S. investors going forward.

So my current posture remains to treat stock market rallies as sell opportunities and interest rate up-moves as trading buy opportunities. 


  1. In the near term wouldn't you expect a flight to quality to Treasurys due to euro turmoil as another factor?

    And if we copy Japan wouldn't AGNC, CYS, NLY and MTGE make sense?

  2. Let us all give grace to those who fell in battle, so that our cherished liberties and independence be the air we breath.

    God's glory upon them; God's wisdom and light shine upon America for all to behold.

    As a freeman standing on my feet, I give thanks to America: and on my knees, I give prayer to my Lord for his wise council and strength.

    May this land always be the beacon of light, for truth, justice and liberties.

    God Bless America!

  3. JB: 1. Yes, though with the caveat that the euro has a huge speculative net short position on the futures market, so a lot of negativity is priced in. 2. Maybe; in a significant recession, they may have lots of downside as in 2008. The pure safe haven play is zero-coupon Treasurys IMHO.

    Hans: Wonderful sentiments. Many things are more important than monetary matters, and I'm glad you added your thoughts.

    I often like to think of JFK's and Reagan's references to the Sermon on the Mount: "You are the light of the world. A city that is set on a hill cannot be hidden."

    Let us hope that America always strives to be the light of the world, a light that never dims.

    1. Thank you, Dr X! The lights on the hill shall be a beacon for all of the world; for those wishing to see..

  4. Doc, do you have any thoughts on ETFs or mutual funds for zeros? The spreads on ZROZ and EDV are a little hard to take. I already own IEF and TLT but those are not zeros.