Saturday, 21 March 2009

Post Bubble Economy endures 20 year bear market

Today, in an interview on CNBC's European Closing Bell I shall be looking at three rather remarkable charts which show correlations between the movements in some key asset classes and I want to tie this into a discussion about the primary reason behind the FOMC's decision this week to begin Quantitative Easing. In a nutshell the Fed is petrified of a deflationary spiral and the charts below will, hopefully, illustrate why they are right to be worried.
Many have commented on the "lost decade" in Japan and this is usually thought to have coincided with the 1990's but in fact the case could be made that Japan has lurched from one bout of recession to another for the last 20 years after the spectacular blow off achieved with the Nikkei 225 almost touching 40,000 at the end of 1989.
What is often not realized is just how closely correlated are the movements of the Nikkei 225 and the yield on the US Ten Year Treasury Note. If we select mid-1990 as the base for a comparison and plot the percentage changes in both, the correlation is quite astonishing as the chart below shows. Not only has the trajectory taken by each been one of very high correlation but also the terminal point on the right hand side of the chart is uncannily coincidental. The base period that has been chosen is mid 1990 so as to avoid the final blow off of the Nikkei 225 but even setting the base a little further back does not really change the picture significantly.
What is potentially alarming for the US policy makers is the possibility that US asset prices could deflate in a very similar manner to that seen in the world's second largest economy Japan. Japanese equities are now back to levels seen more than 20 years ago and that nation's asset bubble of the late 1980's has been entirely eradicated.
A convincing case can be made that the Nikkei 225 has been in a bear market ever since. It is this asset deflation on such an extraordinary scale that should keep central bankers, especially in the US and UK, alert to the possibility that a deflationary spiral is extremely vicious and hard to arrest.
In any observed correlation there is no requirement or implication for a causal relationship as what is being measured is a co-movement of changes.
The underlying or independent variable in this correlation would almost certainly be the yield on the US 10 year and to fully explore the relationship between the two would go beyond the scope of this article. What can be said is that the income being paid out in the form of US Treasury coupons has been in a similar downward trend to Japanese equities throughout the entire period and represents the other side of true asset deflation which is that capital has been increasingly incapable of generating sustainable (non speculative) cash flows as a return to investors. In other words the US Treasury has been able to benefit from the most troublesome aspect of an ongoing and structural asset deflation scenario which is the gradual disappearance of reliable and long lived income streams from the employment of capital. The bubbles in the US market since the mid 90's have produced temporary illusions of asset inflation but now that these have been pierced the true returns to an over abundance of global capital have been revealed as truly elusive.

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