The media has always compared the U.S. to Japan because of its debt burden. Many analysts claim that Japan cannot be compared to the U.S. because Japan has a current account surplus as opposed to the U.S. (Chart 1 and Chart 2) and most of its government debt is held domestically. Still, there are a lot of similarities between the two countries. I will discuss several of them here.
Just recently Japan has come into the picture because the country has started posting current account deficits (Chart 1), mostly due to the economic crisis of 2008, but also partly due to the earthquake of March 2011.
Interestingly, this drop in the Japanese current account surplus (2008 onwards) coincides with a widening gap between tax revenues and total expenditures (Chart 3).
If we compare the budget deficit charts for Japan (Chart 3) and the U.S. (Chart 4), we can see that the U.S. has started to tread in the footsteps of Japan (year 1990) starting from 2008. The budget deficit has widened significantly and this gap between revenues and spending has continued to grow.
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|Chart 4: Tax Revenue Vs. Expenditures Vs. Budget Deficit (U.S.)|
If we look at the debt to outlay ratio between the two countries by dividing the budget deficit by the outlay spending (Chart 5 and Chart 6), we can see that both countries are approaching the 50%-60% level, which is an indicator of highly inflationary periods. It means that more than 50% of spending is financed by debt/deficits.
Another indicator is the interest expense on debt which is ballooning in both countries (Blue Dots) (Chart 7 and Chart 8). Interestingly, the ratio between interest on debt and tax revenues is declining in the U.S. while it is rising in Japan. This is because the U.S. has been benefiting from the reserve currency status of the U.S. dollar, which resulted in low yields on its government bonds. Moreover, tax revenues in the U.S. have been steadily going up, while tax revenues in Japan have declined since 1990.
Even though Japanese bond yields are at historic lows today (10 year Japanese bond yield at 0.73%), it is important to know that interest payments are not decreasing but rising (Chart 7). This ultimately means that yields can be manipulated lower, but there is a point where the debt will be so high that the interest payments will go up no matter how low the yields are on government debt. With this rise in interest payments, the ratio between interest payments and tax revenues will go up too (Chart 7). There will be a point where the market will impose higher bond yields and that is the point where the ratio between interest payments and tax revenues will spike upwards. If Japan were to have a 2% yield on 10 year government bonds, almost all of its tax revenues would go to interest payments on debt. It's easy to see that the same will happen in the U.S. This is why the government will keep interest rates low for as far as the eye can see.
I have stated before that the U.S. bond market is going to implode soon (Chart 9 and Chart 10). Not by rising yields, but by inflation of the currency.
The Federal Reserve cannot afford to have higher yields on its government bonds because interest payments on debt would be unsustainable as I pointed before. I believe that the Federal Reserve has only 1 way to keep U.S. bond yields low and that is to expand the Federal Reserve's balance sheet (similar to the expansion in the Bank of Japan). As a matter of fact, 90% of next year's new bond sales is going to be bought by the Federal Reserve itself. We recently witnessed the new QE3 program which would expand the Federal Reserve balance sheet by $85 billion a month. This expansion of the balance sheet is highly inflationary to the currency of the country. The result is a declining value of the U.S. dollar as can be seen on chart 11. It's fascinating to point out that the euro, with all of its problems regarding unemployment (which is rising very fast lately as I pointed out here), has been outperforming the U.S. dollar since QE3 was announced.
Japan has been manipulating bond yields lower in a similar way and as a result the Japanese yen has shed 10% against the U.S. dollar within a year (Chart 12).
It's difficult to see the big picture here, but it all comes down to this. People have started to back away from the dollar as the Federal Reserve runs out of bullets. Bond yields are now kept low by the Federal Reserve by buying bonds directly in the market and this is highly inflationary to the U.S. dollar. Even though the Federal Reserve tries keeping U.S. bond yields low, U.S. bond prices (NYSEARCA:TLT) have stopped gaining value just recently. From the case of Japan we can see that there is a point where debt is so high that interest payments will go up no matter how low yields on government bonds are. A good sign of people backing away from the U.S. dollar can be seen in the decoupling theory of which I talked here. The Hang Seng Index has been making new highs while the Dow Jones is trending down. Investors should prepare to get out of the U.S. dollar soon and go for emerging market securities like the iShares MSCI Emerging Markets Index (NYSEARCA:EEM) or precious metals (NYSEARCA:GLD) (NYSEARCA:SLV).
Disclosure: I am long PSLV, AGQ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.