23 September 2010

Cross Assets
Special report
www.sgresearch.com

Japan parallels
Not just a case of history repeating itself

Uncertainties abound regarding economic growth and recovery prospects in developed

countries. But the currency trend in these countries has nothing in common with Japan in the
1990s and corporate situations are sound, with limited debt. While we identify some similarities
between Japan’s lost decades and the current situation in the US and in Europe, we carry out a
region-by-region investigation and conclude that the situation is very different.

! Japan’s lost decades

- Japan’s lost decades have been associated with having the strongest currency in the
world.
- Nominal 10-year JGB yields peaked in September 1990 at over 8% and have since
declined steadily.

! Prompt policy response in the US

- The US policy response compared with Japan was both faster and more aggressive.
- The US enjoys good demographics: Japan’s working age population is shrinking, while
the same segment of the US population is still growing.
- In the US, 10-year swap rates have declined some 520bp from their recent peak in 2000.

! No excess leverage in the euro area

- No excess leverage in aggregate on non-financial corporate or household balance
sheets: Local excesses such as in Ireland and Spain, but not on an aggregated level.
- Significant intra-euro area divergence: The euro area has substantial divergence between
member states both on public finances and economic growth prospects.

! Rapid fiscal repair in the UK

- Excess leverage in the UK not located on corporate balance sheets, but on household
balance sheets.
- The UK is committed to rapid fiscal repair and is planning the tightest of the G4 fiscal
policies.

Project manager
Daniel Fermon Michala Marcussen Vincent Chaigneau
(33) 1 42 13 xx xx (33) 1 42 13 00 34 (44) 20 7676 7707
daniel.fermon@sgcib.com michala.marcussen@sgcib.com vincent.chaigneau@sgcib.com

Alain Bokobza Claudia Panseri Kit Juckes

(33) 1 42 13 84 38 (33) 1 58 98 53 35 (44) 20 7676 7972
alain.bokobza@sgcib.com claudia.panseri@sgcib.com kit.juckes@sgcib.com

Notice to US investors: Written by a non-US research analyst not registered/qualified under FINRA Rules
THIS RESEARCH REPORT IS THE PRODUCT OF SOCIETE GENERALE (AUTHORIZED IN FRANCE BY THE AMF)
PLEASE SEE IMPORTANT DISCLOSURES AND ANALYST CERTIFICATION IN THE APPENDIX

Macro Commodities Forex Rates Equity Credit Derivatives

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 Japan parallels

Contents
3 Key conclusions

3 Why some investors believe we are experiencing a Japanese-style lost decade

4 Western economies in much better shape than Japan during the lost decades

5 Japan during the lost decades

7 Comparison with the 2010 US situation

9 What differentiates the US now from Japan then?

10 Comparison with 2010 eurozone situation

12 What differentiates Europe now from Japan then?

13 Comparison with the 2010 UK situation

15 What differentiates the UK now from Japan then?

Thanks to Nicolas Harari for his assistance in preparing this report.

2 23 September 2010

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 Japan parallels

Key conclusions

Why some investors believe we are experiencing a Japanese-

style lost decade
Is history just repeating itself? Although history never repeats itself in exactly the same way,
there are a number of striking similarities between the economic situation the world is
witnessing today and the situation that arose in Japan in the 1990s and indeed in the first
decade of the new millennium (Japan’s so-called ‘lost decades’). Why this period of economic
history can help us understand and forecast outcomes from today’s situation can be summed
up in three words: balance sheet recession.

Today, both the US and Europe are facing the same challenges: fallout from the bursting of
the asset-price bubble, which has led to dramatic declines in equity and real estate prices
versus their peaks. Parallels have been drawn between the current situation and financial
sector behaviour in Japan in the 1980s (when the asset-price bubble burst) and the US
situation at the height of the subprime lending spree in 2008 (see 19 December 2008 report
from SG Economists and SG Quantitative strategists “A historical perspective on the crisis”).
Another similarity lies in bond markets which reached new lows in Europe in August and are
close to bottom in the US. Finally, equity market trends look pretty much the same as they did
in Japan during the lost decades, and this could also fuel investor concerns.

US equity market with 10-year lag compared to Japan US bond market with 10-year lag compared to Japan
7 9
Japanese Real
Estate and 8
6
Valuation Crisis
7
5
6 Bond y ield on a continuing
4 5 downward trend ...

4
3
US 3
Valuation
2
Crisis 2

1 1
Duration (days)
Duration (Days) 0
0

0
500

1000

1500

2000

2500

3000

3500

4000

4500

5000
0

1000

2000

3000

4000

5000

6000

7000

8000

Japan 10-year bond yield (starting in 1990)

US 10-year bond yield (starting in 2000)
Nikkei 225 (starting in 1980) S&P 500 (starting in 1990)
German 10-year bond yield (starting in 2000)
Source: SG Cross Asset Research

However, below we identify two significant factors that illustrate that the root causes of
Japan’s lost decades are not present in today’s situation:
! Japan’s ‘keiretsu’ corporate organisation, with companies grouped together into
conglomerate-like structures, each including a large bank and several corporations, produced
an excessive amount of bad loans.
! Japanese businesses used to be extremely dependent on debt financing, with Japanese
firms five times as leveraged as US corporations in the 1980s. As asset prices were
appreciating steadily, there was no concern about debt repayment. This also involved
widespread use of land at inflated prices as collateral.

These two factors must not be overlooked when comparing the current situation with Japan’s
lost decades. Importantly, these two balance sheet recessions reveal that things were very
different then compared with now when we consider the prevailing economic environment.

23 September 2010 3

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 Japan parallels

Western economies in much better shape than Japan during

the lost decades
Let’s assume that equity markets and house prices have not yet hit bottom and that a further
15-20% decline is still possible.

While the key debate could well continue to focus on whether the US and European countries
are in a similar situation to that experienced by Japan, we note significant structural
differences:
! First, speed of government action: in the US and in Europe, governments acted swiftly to
address the banking crisis, almost immediately recognising and writing off non-performing
loans, in stark contrast to the hesitant approach adopted in Japan. Resolution of the crisis in
the US was facilitated by the rapidity of capital injections, first by the sovereign wealth sector,
and then by the US Treasury.
! Second, currency adjustments. Yen appreciation in the 1990s had a considerable negative
impact on the Japanese economy; conversely, more recently, western countries suffered
currency depreciation versus emerging market currencies and even more recently against the
yen.
! Third, the balance of payments situation is very different. Even during its lost decades,
Japan managed to post a current account surplus, whereas the US and most European
countries have current account deficits at present.
! Finally, population trends. Demographics in Japan were quiet different compared with the
current situation in the US and Europe. In Europe, only Germany and, to a lesser extent, Italy,
could be compared to the demographic situation in Japan during its lost decades. But even
so, property bubbles have not developed in either Germany or Italy. It’s also important to note
that the recent US property bubble was significantly smaller than in Japan in the 1990s.

Population trend with 10-year lag compared to Japan Property trend with 15-year lag compared to Japan
1995 2000 2005 2010 2015 2020 1996 2001 2006 2011 2016 2021 2026
118 118 400 400
Japan population trend
116 US population trend 116 350 350
UK population trend
114 France population trend 114 300 300
112 112
250 250
110 110
200 200
108 108
150 150
106 106
100 100
104 104
50 50
102 102 1980 1985 1990 1995 2000 2005 2010
100 100 Japan residential property price UK residential property price
1985 1990 1995 2000 2005 2010 France residential property price US residential property price

Source: SG Cross Asset Research

In conclusion, while we identify some similarities with Japan’s lost decades and the current
situation in the US and in Europe, in this report, we carry out a region-by-region investigation
and conclude that the situation is very different. Uncertainties abound regarding economic
growth and recovery prospects in developed countries, but corporate situations are sound
with limited debt, and world economic growth appears to be fairly solid.

4 23 September 2010

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 Japan parallels

Japan during the lost decades

40,000 8.00 Movement of rates: Nominal 10-year JGB yields

7.00 peaked in Sept. 1990 at over 8% and have since been
35,000
6.00 in a long-term decline, touching a record low of
30,000 5.00 under 0.5% by May 2003.
25,000 4.00
3.00 Since this low, the 10-year yields have averaged about
20,000 2.00 1.5%, underpinned by strong deflationary pressures
15,000 1.00 and in spite of rising budget deficits.
0.00
10,000
-1.00 The decline in yields and inflation was triggered by the
5,000 -2.00
end of the equity and land price “bubble”. Equities
Oct 87 Jan 91 Apr 94 Jul 97 Oct 00 Jan 04 Apr 07 Jul 10
peaked in December 1989 and land prices in Q3 1990.
Nikkei 10-year JGB Japan CPI Inflation

9.0 300 Shape of curve: As 10-year yields declined, the JGB

curve steepened steadily until Q3 1992. Since then
8.0 250
the curve has stabilised at around 130bp for 2y-10y
7.0 200 JGBs and 58bp for 10y-20y JGBs (a 30-year JGB
6.0
150 issue was first introduced in Sept. 1999).
5.0
100
4.0 The key characteristic of the JGB curve is that it
50
3.0 became very directional: steepening in a sell-off and
2.0 0 flattening in a rally. This reflected policy rates always
1.0 -50 being kept very close to zero and the yield curve
- -100 pricing in a normalisation of BoJ policy rates that has
Oct 87 Jan 91 Apr 94 Jul 97 Oct 00 Jan 04 Apr 07 Jul 10 yet to materialise.

10-year JGB 2y-10y JGB 5y-20y

9.0 70 Swap spreads: JGB swap spreads only started

60 trading in the late 1980s and were very volatile.
8.0
50 Through the end of the 1990s they averaged about
7.0
40 +30bp (IRS –JGB yield) but since 2000 they started a
6.0
30 cheapening process to average about +10bp since
5.0 2000.
20
4.0
10 This coincided, as theory suggests, with the
3.0 0 deterioration in Japan’s fiscal balances (+1.9% of
2.0 -10
GDP average in the 1990s and -4.0% since 2000).
1.0 -20
- -30 As was the case with the JGB curve, ASW*
Oct 87 Jan 91 Apr 94 Jul 97 Oct 00 Jan 04 Apr 07 Jul 10 directionality also switched from negative until the
mid-90s to positive, where it has been ever since.
10-year JGB 10y ASW
*ASW = asset swap
Source: SG Cross Asset Research, Datastream

23 September 2010 5

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 Japan parallels

4.0 140 Behaviour of volatility: Interest rate volatility

(swaptions) started trading only in the mid-1990s,
3.5 120 many years after the start of the 10-year JGB yield
3.0 decline. The product reflected onshore demand for
100
2.5 yield-enhancement products.
80
2.0 Gamma normalised volatilities have been directional
60
1.5 and mean reverting. Vega volatilities have more or
40 less followed the same pattern but, on many
1.0
20 occasions, the payer skew has become “hyper-
0.5
lognormal” primarily reflecting (offshore investor)
- 0
views of a potential fiscal collapse. Such trades have,
Oct 95 Jan 99 Apr 02 Jul 05 Oct 08
on every occasion, failed.
10-year JGB 3mx10y Normal swaption Vol

Currency behaviour: Japan’s lost decades have

been associated with the country having the
strongest currency in the world. The yen has been
both a large part of the reason for the difficulty
experienced in escaping deflation, and a reflection of
falling relative prices – since 1990, US consumer
prices have risen by 71%, Japan’s by just 7%.
What this highlights for the US is the need to maintain
a competitive currency. The 25% dollar appreciation
(on a trade-weighted basis) between the summer of
2008 and February 2009 will be seen as a source of
concern, not pride.

Equity: As is well known, the Japanese market

3500
peaked in December 1989 at a price-to-earnings ratio
3000 in excess of 50x, well above the market’s current P/E.
2500 Topix
The market has since been on a downtrend that has,
2000 however, been interrupted by powerful and investable
1500 rallies.
1000 These rallies were coincident with upturns in the
500 global economic cycle.
0
Jun-89 Dec-91 Jun-94 Dec-96 Jun-99 Dec-01 Jun-04 Dec-06 Jun-09

Source: SG Cross Asset Research, Datastream

6 23 September 2010

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 Japan parallels

Comparison with the 2010 US situation

From their peak in 1990, 10-year Movements of rates in Japan Movements of rates in the US
swap rates in Japan dropped
some 650bp until stabilising 8 10

USD 10y swap [%]

around 1.50% from 1999. In the
JPY 10y swap [%] 650bp
6 8
US, 10-year swap rates have 520bp
dropped some 520bp so far from 6
4
their recent peak in 2000. 4
2 2
Assuming that US rates will level
out after a decline similar to that 130bp
0 0
in Japan, one would expect an
1989 1994 1999 2004 2009 1989 1994 1999 2004 2009
additional 130bp decrease in
rates. Source: SG Cross Asset Research

Japan’s curve steepened from an
inverted -90bp in 2s10s swaps in
1990 to 255bp in 1995, a 345bp
Shape of the curve in Japan Shape of the curve in the US
300
USD 2s10s swp [bp]
JPY 2s10s swap [bp]

move. In the US, the 2s10s slope 345bp

has been extremely volatile since
200
2000, first pushing up from
200
around zero to 300bp, then back 100
to zero and up to 265bp. 100
0 300bp
Most recently, the curve has been
1989 1994 1999 2004 2009 0
flattening again. Some of the
excess volatility in the US is due -100 1989 1994 1999 2004 2009
to non-inversion note hedging.
Source: SG Cross Asset Research

It is not clear whether the JPY Swap spreads in Japan Swap spreads in the US
swap spread is a good
comparison for USD swap 75
JPY 10y spread bp]

spreads. In the US, the swap

spread tends to be more volatile 50
due to mortgage convexity
hedging. 25

However, one observation is that 0

although JPY 10y swap spreads
pushed below zero, they never -25
went below -25bp. In the US, we 1989 1994 1999 2004 2009
have just experienced negative
10y spreads and may expect a Source: SG Cross Asset Research
floor around -25bp as well.

23 September 2010 7

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 Japan parallels

The JPY 3m2y vol dropped to a Behaviour of volatility in Japan Behaviour of volatility in the US
historical low after the
bp/day 20 bp/day
introduction of ZIRP and then 9
ZIRP Quantitative Easing Quantitative Easing
collapsed to as low as 0.3bp/day 8 Lehman
7 15
during the first two years of QE.
6
The 3m10y vol was following 5
short rates vol lower – until the H2 4 10
2003 sell-off. 3
2 5
1
In US, we are observing quite a
0
similar pattern. The 3m2y vol has 0
99 00 01 02 03 04 05 06 07 08
dropped to historical lows and is Jan-07 Jan-08 Jan-09 Jan-10
JPY vol 3M10Y JPY vol 3M2Y
tending to exert a negative effect USD vol 3M10Y USD vol 3M2Y
on longer-tail vol. In absolute Source: SG Cross Asset Research
values, USD rates vol remains
higher than JPY rates vol.

The good news for the US, with Currency behaviour in Japan Currency behaviour in the US
its huge trade deficit, is that
undermining the dollar is far 155 Japanese Yen to USD
easier to achieve than weakening 145 Yen
the yen appears to have been. US appreciation
135 Yen
devaluation/debasement policies appreciation
125
remain intact.
115

The fear, then, must be that in 105

running policies designed to avoid 95
being like Japan, at all costs, the 85
US will end up with something
75
very different indeed – 1989 1992 1995 1998 2001 2004 2007
successfully undermining the Source: SG Cross Asset Research
dollar and ultimately causing a
return of inflation.

Equities in the US peaked in Equities in Japan Equities in the US

October 2007. They rallied sharply
from March 2009 to April 2010. 3500 1600

1500
3000
S&P 500
They have been trending lower 2500 Topix
1400

1300
since. This pattern is similar to the 2000
1200
Japanese price action between
1500 1100
the second half of 1992 and the
1000 1000
first half of 1993. Financials 900
initially led the market higher in 500
800
both cases. 0
Jun-89 Dec-91 Jun-94 Dec-96 Jun-99 Dec-01 Jun-04 Dec-06 Jun-09 700

600
Mar-07 Jan-08 Nov-08 Sep-09 Jul-10
Reassuringly, the US equity
market was not as expensive as Source: SG Cross Asset Research

the Japanese one at the peak.

8 23 September 2010

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 Japan parallels

What differentiates the US now from Japan then?

Similarities Differences
Excess leverage The private sector took on excess leverage Excess leverage, but not on corporate balance sheets US
in the pre-crisis period fuelled by over optimism, financial excess leverage is on the balance sheets of households and small
deregulation and a lax attitude to credit. businesses.

…and asset prices bubbles Asset price bubbles resulted Prompt policy response The US policy response was both
from the situation above; eventually those bubbles burst. faster and more aggressive than that of Japan.

Bank failures The crisis resulted in the failure of systemically The US enjoys good demographics Japan’s working-age
important financial institutions. population is shrinking, whilst the US’s is still growing.

Explosion of public deficits Public deficits have widened The US is a deficit economy with no structural demand
substantially, due to the crisis but are also burdened by problem The US depends heavily on foreign investors, unlike
structural issues. Japan.
Reform: The crisis triggered deep-rooted reform of the financial The US dollar is the world’s reserve currency This offers an
sector.
advantage as many players worldwide have a vested interest in the
greenback.

The US end-game - External rebalancing

6.0
% of GDP

4.0

2.0

0.0

-2.0

-4.0

-6.0 US Japan

-8.0
85 87 89 91 93 95 97 99 01 03 05 07 09

Source: SG Cross Asset Research

SG view
Like Japan in the lost decades, the US is today suffering de-leveraging pressures.
However, we cannot conclude that the US is facing a structural demand problem. On the
contrary, the external deficit suggests a shortage of savings, which, from a structural
standpoint, should be pressuring the dollar lower and bond yields higher.

23 September 2010 9

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 Japan parallels

Comparison with 2010 eurozone situation

JPY long-term rates eventually Movements of rates in Japan Movements of rates in Europe
stabilised at 1.50%, excluding the
“bubble” period of H1 2003. EUR 10 10-yea r JGB 10y Bund
IRS do not go back as far back as JPY 10y swap [%] 8 9
the late 1980s but 10-year Bunds 650bp 8
6 7
at 2.11% by end Aug-2010
6
suggest that the yield downside in
4 5
core EUR rates may be lot more
4
limited than in USD: 50-60bp if 2 3
BEI indeed contract to Japan- 2
style levels. 0 1
0
1989 1994 1999 2004 2009
Sep 89 Sep 92 Sep 95 Sep 98 Sep 01 Sep 04 Sep 07 Sep 10
Source: SG Cross Asset Research

As in the US, the EUR curve has Shape of curves in Japan Shape of curves in Europe
become very directional, i.e.
driven by the long end. The curve
flattens as rates fall, and steepens
as rate rises.

In a bullish environment the curve

would flatten aggressively again,
as there is limited scope for 2y
yields to move to the downside. In
a low-yield environment, the
curve segmentation implies that
10-30y lags 2-10y on the
flattening move. Expect the 2-10-
30y barbell in EUR to fall further in
Source: SG Cross Asset Research
a Japan-style bond rally.

The German fiscal situation is far Swap spreads in Japan Swap spreads in Europe
better than that in Japan. It also
appears healthier than that of 75
JPY 10y spread bp]

most its EU partners, so German

bonds tend to benefit from flight- 50
to-quality flows in a crisis
environment. This would most 25
likely be the case in a low-
growth/low-inflation environment 0
that would make the fiscal
consolidation of non-core EMU -25
ever harder to achieve. So 1989 1994 1999 2004 2009
German swap spreads may not
reverse as they occasionally did
Source: SG Cross Asset Research
in Japan. Our swap spread model
predicts low but positive EUR
swap spreads over the coming
year

10 23 September 2010

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 Japan parallels

Long-tails of EUR implied Behaviour of volatility in Japan Behaviour of volatility in Europe

volatilities traded at similar levels
bp/day 11
to JPY (excluding the JGB 9 bp/day
ZIRP Quantitative Easing 10
bubble), especially during 2004-07 8
7 9
when structured products were 8
most popular. If deflationary 6
5 7
expectations materialised in the 6
4
eurozone and the ECB responded 5
3
with QE-type measures, most 4
2
downside on EUR volatility would 1 3
be on short-tails. The volatility 0 2
surface would likely become 1 EUR vol 3m2y EUR vol 3m10y
99 00 01 02 03 04 05 06 07 08
steeper too. 0
JPY vol 3M10Y JPY vol 3M2Y 99 00 01 02 03 04 05 06 07 08 09 10
Source: SG Cross Asset Research

Deflation is not the direct driver of Currency behaviour in Japan Currency behaviour in Europe
the trend in the euro. Arguably,
175 Japanese Yen to €
Europe is more at risk of Japan-
style deflation than the US is. 160
Yen
appreciation
However, the last year has shown
that deflation presents a very 145

different threat for Europe as it

130
could dramatically exacerbate the
deterioration in peripheral nations' 115
fiscal position. The driver of the
100
trend in the euro will therefore be
how fear of default evolves. 85
1999 2001 2003 2005 2007 2009

Source: SG Cross Asset Research

The European equity market Equities in Japan Equities in Europe

peaked in July 2007. Like the US
3500 450
market, it bounced between early
STOXX 600
March 2009 and April 2010, again 3000
400

mirroring the 1992-93 Japanese 2500 Topix

350
price action. As in Japan, these 2000

gyrations have been driven by 1500 300

cyclical indicators. 1000

250
500

200
0
Jun-89 Dec-91 Jun-94 Dec-96 Jun-99 Dec-01 Jun-04 Dec-06 Jun-09
150
Apr-07 Feb-08 Dec-08 Oct-09 Aug-10

Source: SG Cross Asset Research

23 September 2010 11

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 Japan parallels

What differentiates Europe now from Japan then?

Similarities Differences
Excess leverage on financial sector balance sheets The No excess leverage in aggregate on non-financial corporate
financial sector took on excess leverage in the pre-crisis period or household balance sheets Localised excess in Ireland,
fuelled by over optimism, financial deregulation and a lax Spain, etc., but not on an aggregate level.
attitude to credit.
Real-estate bubbles only localised: even though many euro
Bank failures The crisis resulted in major tensions. area countries saw firm real estate gains in the pre-crisis era

A structural demand problem Structurally deficient labour Large intra-euro area divergence The euro area member
markets and fiscal tightening plead for weak income growth. states show a marked divergence in both public finances and
economic growth prospects.
Explosion of public deficits Public deficits have widened
substantially due to the crisis, but are also burdened by No single fiscal policy The euro area does no enjoy the
structural issues. benefits of a single central strong fiscal authority.
Reform The crisis has triggered deep-rooted reform of the
financial sector.

A very different picture on balance-sheet leverage

Euro area Household debt to GDP ratio (% GDP) Euro area Non-Financial corporations debt to GDP (%)
140 200
2003 2009 2003 2009
180
120
160

100 140

120
80
100
60
80

40 60

40
20
20

0 0
Germany

Germany
Portugual

Portugual
Belgium

Malta

Belgium
Finland
France
Greece
Ireland

Slovakia

Malta
Luxembourg

Finland
France
Greece
Ireland

Slovakia
Luxembourg
Cyprus

Italy

Netherlands

Cyprus

Italy

Netherlands
Spain

Slovenia

Spain

Slovenia
Austria

Austria

S C SG G\ \ \ C \ \ \ C C

Source: SG Cross Asset Research

SG view
While we find that both the household and corporate sectors in the euro area have
significantly increased their net saving, the balance sheets for both sectors do not indicate
there has been a huge destruction in wealth on a Japanese scale. This suggests that there
is little risk of a balance-sheet recession in the euro area. Instead, we are concerned that
the euro area will suffer a structural inability to generate sufficient aggregate demand to
make use of the economy’s available resources.

12 23 September 2010

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 Japan parallels

Comparison with the 2010 UK situation

The UK, like Japan, has now
Movements of rates in Japan Movements of rates in the UK
pursued full-blown government
bond-buying quantitative easing
to an extent not yet tried in the US % 14
3
10Y GBP Swa p ra te
or the euro area (where central
2 12
bank action was closer to “credit 10
easing”). The UK yield 1
8
composition contrasts sharply 0
with Japan. In the UK, 10y
6
-1
nominal and inflation swap rates 4
-2 2
are both c.3.25%, so the real yield 10y JPY
is zero. In Japan, a negative 10y -3 10y JPY Inflation 0
inflation swap rate leaves the real 01/08 07/08 01/09 07/09 01/10 07/10
rate still significantly positive.
89 94 99 04 09
Source: SG Cross Asset Research

In the UK, one characteristic Shape of curves in Japan Shape of curves in the UK
feature of the crisis has been the
reluctance of long-dated forward % %
4 6
yields to fall. Perhaps – like Japan
– this reflects distant credit and/or 3 5
inflation fears, that quantitative
easing might even encourage.
2 4
From a receiving standpoint, we
regard forward yields that are now
1 3
back above pre-crisis levels as 10y GBP 10y20y GBP
10y JPY 10y20y JPY
attractive.
0 2
03 04 05 06 07 08 09 10 03 04 05 06 07 08 09 10

Source: SG Cross Asset Research

10-year gilt swap spreads, now at Swap spreads in Japan Swap spreads in the UK
7bp, traded below zero for most
175 6
of H1 2010. This is not surprising,
80 150 4
given the relationship with the
125 2
deficit (charted). However, we 60
expect spreads to remain in 100
JPY 10Y spread, bp 0
positive territory given: i) the carry 40 75
-2
earned on long ASW positions; ii) 50
20 -4
the ongoing demand from banks 25
to hold risk-free assets for 0 -6
0
liquidity purposes; and iii) -25 10-year ASW, LHS, bp -8
expected future improvements in Budget Deficit/GDP, %, RHS inverted
-20 -50 -10
public finances. 88 90 92 94 96 98 00 02 04 06 08 10
98 00 02 04 06 08 10

Source: SG Cross Asset Research

23 September 2010 13

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 Japan parallels

Behaviour of volatility in Japan Behaviour of volatility in the UK

The “Japanisation” of markets,
characterised by bull flattening bp bp 1y->2y GBP NormVol
and bear steepening, is reflected 1y->2y JPY NormVol 150
in the term structure of volatility in 100 1y->10y GBP NormVol
1y->10y JPY NormVol
the US and euro area. The UK 80 130
stands alone in resisting 1y->10y 110
normalised volatility pushing 60
below 1y->2y. 40 90
20 70
0 50
00 01 02 03 04 05 06 07 08 09 10 00 01 02 03 04 05 06 07 08 09 10
Source: SG Cross Asset Research

If there is a major economy where Currency behaviour in Japan Currency behaviour in the UK
deflation appears a limited risk, it 300
is the UK. Inflation is proving very Japanese Yen to £
280
sticky and that, in turn, is 260 Yen
anchoring inflation expectations. 240 appreciation
Yen
This brings its own problems for 220 appreciation
policy-makers, but there is no 200
similarity between the Japanese 180
deflation experience and what the 160
UK's MPC faces. 140
120
100
1989 1992 1995 1998 2001 2004 2007

Source: SG Cross Asset Research

The UK market peaked in June Equities in Japan Equities in the UK

2007. Like the European and the
US equity markets, it staged a 3500 4000

powerful bounce between March 3000

2009 and early 2010. 2500

Topix 3500

FTSE All Share

2000
3000

1500

1000 2500

500
2000
0
Jun-89 Dec-91 Jun-94 Dec-96 Jun-99 Dec-01 Jun-04 Dec-06 Jun-09
1500
Jun-06 Apr-07 Feb-08 Dec-08 Oct-09 Aug-10

Source: SG Cross Asset Research

14 23 September 2010

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 Japan parallels

What differentiates the UK now from Japan then?

Similarities
Excess leverage The private sector took on excess leverage
in the pre-crisis period, fuelled by over optimism, financial
deregulation and a lax attitude to credit.
…and asset prices bubbles Asset price bubbles resulted
from the situation above; eventually those bubbles burst.
Bank failures The crisis resulted in the failure of systemically
important financial institutions.
Differences
Excess leverage, but not on corporate balance sheets UK
excess leverage is on household balance sheets.
Prompt policy response The UK policy response was bold and
fast, contrary to that of Japan.
The UK is committed to rapid fiscal repair The UK is planning
the tightest of the G4 fiscal policies.

Explosion of public deficits Public deficits have widened

substantially due to the crisis, but are also burdened by
structural issues.
Reform The crisis has triggered deep-rooted reform of the
financial sector.

Fast-track increase in the household savings rate

16
Saving ratio
14
12
10
8
6
4
2
0
-2
80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10

Source: SG Cross Asset Research

SG view
The UK, in common with many other developed economies, has experienced the deepest
recession in post-war history. The economy is now recovering but this has come at a heavy
price. The legacy of the fiscal and monetary stimulus necessary to achieve that stabilisation
and recovery will be with us for many years as the government struggles to reduce its debt
burden and the central bank ponders how to return to some kind of normal monetary policy.

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 Japan parallels

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