Bond Investors, Beware of Assuming the U.S. Is on Japan's Deflationary Path

Deflation in Japan
Deflation in Japan

A jarring collapse in the stock and real estate markets two decades ago doomed the Japanese economy to painful deflationary conditions, and the country hasn't managed to crawl out since. With the U.S. now facing similar economic forces, deep deflationary conditions are nearly inevitable here as well, according to much of the conventional wisdom.

Investors who buy into the view have piled into supposedly safe assets like U.S. government bonds despite the meager yields they're currently offering. Steady income from solid assets doesn't sound like a bad deal in anticipation of perpetually falling prices, after all. And some investors calculate that relative yields mean the credit market is implying a 70% chance of Japanese-style malaise in the U.S.

However, last week's tremors in the Treasury market following a spate of better-than-expected economic data should serve as a reminder that investors could end up seeing the value of their bonds drop sharply if things turn out differently than that scenario of a deflationary spiral. And major structural and cultural differences between the U.S. and Japan mean that those simply using Japan as a template for how things will unfold here may be overlooking important factors.

Did Japan Make a Collective Choice?

To hear most deflationists tell it, the deflationary scenario is a matter of sheer economic determinism. Presumptions of human behavior like the perpetually mentioned effect of consumers deferring purchases as prices fall only to lead to a further downward price spiral are paramount.

Yet analysts recently have started to note that things are hardly that simple. Not only was Japan's lost decade not as dreaded as it is sometimes made out to be but it may in part have been a collective choice in the wake of the bursting of an epic bubble. And in stark contrast to what credit markets seem to be predicting, it may be a far more remote possibility in the U.S.

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"Whether actively or passively, Japan made a social decision to entrench deflation," Morgan Stanley analyst Robert Alan Feldman wrote in a research report last week. Feldman points to "central bank institutions, demographics, the electoral system's representation of older citizens, and the current account balance" as factors that interacted to create persistent deflation.

Unlike the U.S. Federal Reserve, the Bank of Japan long lacked any explicit goals of price stability or inflation, for example. And Japan's famously aging and politically privileged population made deflationary conditions far more desirable then they might be in the U.S. Huge current account surpluses made financing large government deficits easy and helped reinforce deflationary tendencies.

A Very Different Turn Here?

And while many investors think deflationary spirals are inescapable, "escape was not only possible but was actually within reach in 2006," Feldman noted. "However, Japanese society decided to return to deflation."

With strong population growth, comparatively younger demographics, trade deficits and a tendency to favor growth over stability, the U.S. could take a very different turn. And that could easily wreak havoc on a complacent bond market expecting an inevitable rerun of Japan.