Downgrade Comment

I just want some of the doomsayers to realize that Japan was downgraded by S&P to AA- in late January, and they threatened to take it farther down after the tsunami.  That would make Japan’s long-term rating single-A (plus) if they follow through, which would make Japan three full “notches” lower than the AA+ the US Treasury now holds.

So, if you listen to the news, this would now make all borrowers pay more, etc. etc.  So what is AA (minus) rated Japan paying these days?

Answer: 1% yield for 10-year Japanese Government Bonds.  Hmmm.

Maybe Japan doesn’t have the same debt problem we do?  Nope.  Their debt is twice their GDP, and ours is less than half that.  Maybe Japan doesn’t have the same problem of an aging population?  Nope.  They are older than we are, have fewer younger workers than we do, and they live years longer than we do once they reach retirement.

So don’t panic (yet).  We should be so lucky as to pay the same interest rates as the Japanese do with their twice-as-bad national debt and their credit rating that is two notches lower than ours.

Wait and see what the market says.


Comments and a reply after the break.

Bruce and others have justifiably pointed out the difference between Japan and the US.  In fact, there are more differences than they have brought up, and those all contribute to the low yield at which JGBs (Japanese Government Bonds) trade.

I’ll respond here in the body of the post.  Let me say that I am not a Pollyanna living in denial over the downgrade.  I just want people to realize that market forces are far stronger than ratings.

That’s even more true today after the mortgage market meltdown.  The days of buying the rating without looking at fundamentals are (thankfully) OVER.  At least until the generation that learned this painful lesson shuffle off the playing court, and maybe until their children also stop being a force in the markets of the future.

That’s in keeping with my “economic lifetime of a generation” theory for the natural length to Nikolai Kondratyev’s wave formation.

OK — the differences

  1. The US Dollar serves as a global reserve currency, so it is held in large size outside the country of origin.
  2. Japan has a large pool of domestic savings that fund most of their borrowing.
  3. Japan tends to run a trade surplus, so it does not have the balance of trade pressure that continually inflates away the value of the currency for countries with trade deficits.

There is no doubt that reason number 3 – the balance of trade – requires that interest rates on long term debt adjust themselves to the reality of that surplus or deficit.  As long as the Japanese economy can produce a surplus (one that only gets reversed when imported energy prices spike up), they will experience a natural downward bias on their interest rates.  It’s probably worth a couple hundred basis points over a multi-decade time frame.

The argument that domestic investors don’t demand higher yields for some “patriotic” reason holds no water for me.  I’ve worked for a major Japanese financial institution.  They were plenty patriotic.  But short of war and purchase of Liberty Bonds, I would not expect them to volunteer to take lower profits (or losses) to help their government hold down its debt service costs, any more than I expect Citicorp or Met Life to bid 2% yield on US Treasury bond auctions to help America’s deficit.

The reserve currency argument is the most intriguing, because it can’t be proved one way or another, since there has been only one reserve currency throughout this K-wave (dated to “start” off a bottom in long-term rates in 1949).  Maybe the global reserve currency has embedded inflation/deflation that relates to the global economy.  I don’t know how you would prove or disprove that theory, since the system is self-referential.  Les McCann and Eddie Harris’ classic from one of my most treasured vinyl LP’s comes to mind — Compared to What?

6 Responses to Downgrade Comment

  1. George says:

    Thanks for the bucking up, Howard. I think I’ll take a pass on the Sunday news shows this week.

  2. David Ericson says:

    I agree with you, Howard. I’ll be surprised if rates rise due to this (possibly criminal/certainly recklessly negligent organization) S & P call.

    Japan, of course, has a fairly captive audience of Japanese savers to fund public debt. The USA depends on the largest, most liquid public debt market in the world (where else can you park billions, if not trillions?) due to its reserve currency status.

    But both ultimately depend upon investor confidence, however. Though shaken in each case, confidence is still intact — for now.


  3. Bruce B says:

    These bond ratings are fascinating things. One who is not smart enough to be among the financial elite in the country might think along the following lines.

    Can the U.S. (or Japan for that matter) ever pay back its debt in full with a currency that is equal in value to the currency that was lent to them in the first place? The obvious answer is no. How in the world can a borrowing entity that can’t pay back in full ever have AAA in the first place?

    If the market views U.S. debt as just as safe today as it was yesterday, why does it care what the discredited S&P says? It also appears that S&P boxed themselves in to a corner. When they stated during the debt negotiations that they needed $4T in cuts to not downgrade, they had no choice but to downgrade once deficit reduction did not come close to that level. They are probably remorseful about that as they will now be loathed by the elite, failed central planners of our economy.

  4. Can you comment on David’s and others constant drumbeat regarding Japanese debt being held in large part by its own citizens? I can’t see the Japanese investor throwing his own country under the bus. I, however, a proud10th+ generation American, have shorted as many US Treasuries as I can afford (to lose if I’m wrong).

  5. Howard,
    I agree to your point that a Japanese institution has no “patriotic” inclination to hold a bad investment, Japanese sovereign debt or otherwise. But am I correct in thinking that they are not the natural buyers (holders) and it is rather the salary man who is? Isn’t it the salary man who ultimately decides where he puts his savings?

    • hhill51 says:

      Actually the salaryman is more likely to get a weekly allowance, and that little lady walking three paces behind is controlling the purse. When I was at Daiwa we had an enormously effective sales force of part-time women brokers… kind of like Avon Ladies.
      In times past, household fixed income savings tended to be in Postal Savings accounts. Brokerage purchases tended to be stocks or mutual funds. Having said that, the Postal Service used to be the single largest holder of JGB’s. But, like Nippon Life, institutional rules apply to their investment decisions.

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