Despite the feverish efforts of policymakers, including a new round of money printing by the Federal Reserve, the U.S. economy continues to dance on the edge of oblivion. Job growth has stalled. The stock market sits just a couple of percentage points above where it was a year ago. Fed up and fearful, investors are throwing their cash at the seemingly safest asset class of them all -- Treasury bonds -- and pushing long-term interest rates to historical lows.
Now, some are wondering whether America is destined to repeat Japan's 20-year battle with deflation, or falling prices, a bear market for stocks and housing, and relentless recessionary pressure.
According to Merrill Lynch strategist Michael Hartnett, this "Japanification" of our economy would be dismal: Interest rates would remain near 0% through 2020; the economy would grow at an average annual rate of just 1% over the next 20 years; the Dow Jones industrials ($INDU) would drop below 4,000; and home prices would fall an additional 46% by 2030.
Even after all we've been through over the past three years -- 7.3 million lost jobs, government bailouts, foreclosures and stock market losses -- this may be a bit too hard to believe. Yet many investors are already preparing for this dark future.
The bond bubble speaks
To be sure, the pessimists are about to be thrown some red meat. After being dealt a one-two punch by the European debt crisis and the fading of government support initiatives, the U.S. economy is stalling. Because of less construction work, fewer exports and smaller inventories, the government on Friday is expected to downwardly revise its initial estimate of growth of gross domestic product in the second quarter to just 1%.This is whipping up fear on a scale not seen since early last year. In fact, the demand for safer investments is so great that in places such as the United Kingdom, government bonds are offering yields below the prevailing inflation rate. In the U.K., 10-year yields on those bonds fell below 3% last week, while consumer inflation stands at 3.1%.
Essentially, this means investors in U.K. government bonds are willing to earn a negative return after inflation in exchange for the safety of knowing that most of their money will be returned in 10 years. U.S. investors aren't far behind: The 10-year Treasury note is yielding 2.6%, compared with a 1.3% consumer inflation rate. And producer prices are rising at a 4.1% annual rate, suggesting higher inflation is on the way.
With talk of bankers whipping up support for exotic 100-year corporate bonds (remember talk of exotic mortgage securities back in the go-go housing days?), people are increasingly worried that a bond bubble -- a bubble in pessimism -- is beginning to develop. I'd include myself in that camp.
Not so, says Julian Jessop, the chief international economist at Capital Economics. In a recent note to clients, he said he sees "no compelling reason why bond yields cannot remain close to their current lows, or even fall further."
Simply put, we've yet to see bond yields fall to levels that couldn't be justified by fundamentals. Jessop writes that "the current low levels of bond yields are consistent with the prospect of a very long period of near-zero short-term interest rates, low or negative inflation and lackluster returns on other assets that increase demand for the safety of government bonds."
In other words, people are preparing for Japanification. And they're positioning their portfolios for deflation.
But what are the chances the U.S. will suffer the sort of malaise that has affected Japan since 1989?
Stars align
Just to be clear, I don't believe this nightmare scenario will come to pass. I'll explain why in a minute. But aside from the pessimistic economists and strategists warning of Japanification, market technicians are seeing signs that America's economic stars are aligning with Japan's. In fact, the Nasdaq Composite Index ($COMPX) is tracing out a pattern eerily similar to the one traveled by the Nikkei 225 ($N225) more than 10 years ago.You can see this in the chart below, where the Nasdaq's March 2000 peak aligns with the Nikkei's December 1989 peak.
Of course, this relationship could change. And the correlation broke down somewhat between 2003 and 2007. Still, that there is any relationship between seemingly random price movements that happened so far apart in time and space is pretty amazing.
The closeness of the fit between these two patterns suggests the U.S. is on the same boom-and-bust path that Japan followed 10 years ago. And if it continues, it suggests U.S. stocks won't find a final low until 2012.