By Jamie McGeever

ORLANDO (Reuters) – Remember ‘Japanification?

The 2008 financial crash led to a consensus that Europe and America would experience the same economic crisis as Japan in many decades. Japan’s property bubble of 1990s caused a wave of excessive savings, low growth and constant deflationary pressures.

The diagnosis was called “Japanification” and involved low interest rates or zero bond yields. There were repeated bouts of bond buying ‘quantitative ease’ as well as mounting debt.

COVID-19 was a major event that many people doubled down upon.

Yet, the inflation rate in Europe and the United States has reached its highest level in more than 40 years.

Initially dismissed as being temporary because of the base effects and bottlenecks after the pandemic, prices are rising more consistently than central banks expected. Some are even raising interest rates.

A shock in energy prices caused by Russia’s invasion and occupation of Ukraine has made the situation worse. U.S. Treasury bonds are experiencing their worst quarter for at least 25 year.

Is the Japanification thesis dead now?

Steve Major, head global fixed income research for HSBC says that it is very alive. He cites three main reasons. These are the Fed’s recent ‘dotplot’ projections and current market prices. And the structural drivers long-term which existed prior to 2008.

Federal Reserve policymakers raised this month their median projections of rates at their peak, to 2.8% next Year from 2.1% in 2024. This is according to their December forecast.

This puts us well beyond’restrictive territory’, which is rates that are higher than the Fed’s long-term neutral assumption. It increases the likelihood of a recession and will likely see bond yields and rates drop quickly again.

This view is supported by several measures of yield curves and rates, including forward, real and nominal.

Importantly, Fed policymakers also reduced their long-term neutral rates forecast to 2.4%. This is a significant change from the 2.5% they had used since 2019. This isn’t a rounding error. It is the result of three policymakers changing their long-term outlook.

The Fed basically indicates that long-term trends for neutral rates of interest are still down because the economy can’t withstand higher rates.

The deflationary pull of rising and huge debt, ageing population, wealth inequalities, rapid technological advancements, and large and growing amounts of debt is powerful.

These trends are extremely powerful, and the central bank cannot control them. Major asked if the central banks could control age. Major replied, adding that “the ‘lower for a longer’ hypothesis remains in place.” It is supported by the market right now.

R-STAR ZERO

The recent pandemic has cast doubt over long-held beliefs that the effects of ageing on worker supply and demand are just as deflationary in Japan.

One of the most compelling arguments, as outlined by Charles Goodhart (economist) and Manoj Prhan shortly before the pandemic was that workers shortages will eventually increase the bargaining power and wage rates and lower prices overall.

However, demographics have a dual impact on long-term interest rates. While potential growth rates are decreasing with ageing and shrinking labor force, workers approaching retirement save their money for safer bonds.

As we see now, there are some opportunities for rising bond yields and inflation, but these are not likely to last.

Surprisingly, one Fed rate-setter who is the most aggressive revealed that the Fed remains in favor of the “lower for longer” outlook.

James Bullard of the St. Louis Fed voted in favor of a 50-bps rate rise. He voted against Fed’s April 16th 25-basis point interest rate hike to 0.25-0.50%. He now calls for rates to increase beyond 3%.

However, he sees the long term equilibrium policy rate as being at 2%. The Fed bringing inflation down below its target at 2% would result in a zero real policy rate known as the ‘R-star.

R-star estimates vary, and the Fed’s median estimate of 0.4% is currently available. So zero wouldn’t be surprising. The New York Fed did not update its estimates for 2020 because of the pandemic. However, the trend is down.

Societe Generale’s Albert Edwards (OTC:), has been a long-term bond bear for all of these structural reasons. He correctly called the fall in yields as part of his “Ice Age” view of global markets and the economy.

According to him, a thaw will eventually come and inflationary pressures from rising commodity and energy prices as well as fiscal excesses and growing deficits will cause the bond market to crash and overwhelm.

This quake, despite all the efforts to re-price bonds in the midst of the recent central bank hawkishness, is not the biggest.

This is not the end of bond bull markets in the short term. Edwards explained that the rise in commodities could lead to global deflation and threaten global demand. “The Fed is going tightening until they bring down the economy, which won’t be very soon.”

Edwards believes the record can be reestablished at 0.5% starting in August 2020, which is a historic level associated with Japanese yields.

(The views expressed in this article are the opinions of the author. He is a columnist with Reuters.

(By Jamie McGeever. Editing by Andrea Ricci.