The Federal Reserve Took Another Big Step Toward “Japanification” of the U.S. Economy

By John Banks

On Thursday of last week, the Federal Reserve made another surprise move. It caught markets by surprise, sent gold stocks through the roof, and accelerated the Japanification of the U.S. economy.

What is “Japanification,” you ask?

It’s the process by which the U.S. economy starts looking like Japan’s economy, which has been stuck in the mud for three decades.

The Bank of Japan (BOJ) has thrown everything but the kitchen sink at the problem, and maybe the kitchen sink, too, come to think of it. Nothing has worked. The more that the U.S. economy resembles Japan’s, the more this looks like our fate.

First, a little background:

Japan had a mind-blowing stock market bubble in the 1980s, and their real estate bubble was even crazier than the stock market bubble.

There is one 1980s statistic that captures what “bubble” really means. The Tokyo Imperial Palace sits on 1.15 million square meters of land in the heart of Japan’s capital. At the peak of Japan’s bubble, that single patch of land was reportedly worth more than all the real estate in California.

And then, at the end of the decade, Japan’s great bubble popped.

The Nikkei 225, Japan’s version of the S&P 500, hit its all-time high on Dec. 29, 1989. It has never since returned to that high.

Even today, more than 30 years later, the Nikkei is trading at roughly half the level of its 1989 peak. That is what it means to be stuck in the mud for decades.

To be sure, Japan’s stock market has had giant up-and-down moves. It’s just that the entire roller coaster ride has taken place far below the high-water mark — without making any real progress.

This could happen to U.S. markets, too.

In the “TradeSmith Market Update” recorded with Keith Kaplan last week (you can access that recording here), we explained, among other things, why it’s possible the S&P 500 has topped out for the entire decade.

If Japan’s main index can get stuck for 30 years, ours could get stuck for 10.

If the U.S. undergoes “Japanification” — that is to say, if the U.S. economy mimic’s Japan’s — we will see events and activities like the following:

  • A stock market that goes nowhere, other than violently up and down within a range, for 10 years or more (the full length of the 2020s).
  • An explosion in the U.S. total debt load — think tens of trillions more — with much of the debt purchased outright by the Federal Reserve (much as the BoJ has done for a while now).
  • Persistent deflationary pressures (wages and prices falling, rather than rising) along with quarter after quarter of flat-to-negative GDP growth, making it very hard, if not almost impossible, to get the economy moving again.
  • Persistent “real” interest rates that are punishingly high, even with nominal interest rates that are low (or even zero). In the midst of debt deflation, interest rates at zero don’t help anything because so few want to borrow.
  • An increasingly active Central Bank, buying huge quantities of assets, dreaming up increasingly bizarre forms of quantitative easing (QE), and trying all kinds of crazy strategies to get the economy out of the doldrums — including the purchase of exchange traded funds (ETFs).

It’s that final bullet, relating to Central Bank ETF-buying, that the Fed engaged in last week.

Japan’s central bank has been buying equity ETFs — intervening directly in the stock market through ETF purchases — since October 2010.

Japanese politicians first made the equity-buying suggestion in the 1990s, after Japan’s burst-bubble aftermath had already dragged on for years.

The Bank of Japan didn’t want to take such a big step, though, because buying ETFs seemed nutty.

But then, in 2010, the BoJ finally threw up its hands. Nothing else seemed to be reviving the stock market or the economy, so they started buying ETFs as a last-ditch effort.

Ten years later, the Federal Reserve is doing it, too.

On Thursday of last week, gold stocks exploded to the upside, and the U.S. dollar fell on news that the Federal Reserve would start buying junk bond ETFs as part of its support for credit markets.

The world’s most powerful central bank is now going to backstop the debt of highly risky companies, not just blue chips. And they are going to do it by purchasing ETFs — just like the Bank of Japan since 2010.

At first, when the Fed announced it would make unlimited bond purchases, the assumption was that the purchases would be “investment grade” only.

Now, though, with junk bond ETFs in the mix, the Fed is telegraphing it can, and will, buy virtually any asset it wants.

This is bad for the U.S. economy on all kinds of levels.

The most obvious problem is that, when a government-backed agency starts buying risky debt and supporting the market outright, it creates a new class of “zombie” companies — entities that should have disappeared, but artificially live on.

The U.S. already had zombie companies as a result of the 2008 financial crisis and the aggressive support programs that followed it. But now the problem could become a lot worse.

Gold stocks rocketed higher on the Federal Reserve news because the Fed is sending a signal: It is now willing to support almost anything, and to buy anything credit-related that isn’t nailed down, in the name of keeping the economy going.

Policies like this have one of two general outcomes. They either create a “stuck in the muck” economy — of the kind Japan has been experiencing for 30 years — or they lead to stagflation, the nightmare situation where inflation rises sharply in the midst of a downturn or recession.

Stagflation is what we had in the 1970s, and the Fed has greatly increased the odds of going back there.

If the government’s response is to flood the system with liquidity and artificial purchases in all kinds of ways, on a scale never before seen, then in the long term, we are likely to see less economic growth, not more. That is because, when the government does too much for too long a period, economic signals and price discovery mechanisms get distorted.

In the “TradeSmith Market Update” recorded last week — again you can access that here — we explained why the U.S. stock market bottom is likely not in, and why the market is unlikely to make new highs any time soon.

But there was one caveat included in the explanation — the possibility that the U.S. government wades in and just starts buying stocks outright.

If something like this occurs, stocks might indeed go up a lot — but the long-term consequences would be horrible, along the lines of the 1970s in the near-term and “Japanification” longer term.

With the Federal Reserve now openly buying junk bond ETFs, they are following in the BoJ’s footsteps. There is a 10-year time lag thus far — but the Fed could catch up fast.

This is not good news for the U.S. economy. But it looks like fantastic news for gold stocks.