A Negative Interest Rate World
Market Update 8-25-16
The FT reports that the value of negative-yielding bonds - both government and corporate - swelled to $13.4 trillion this week as negative interest rates and central bank bond buying ripple through the debt market.
The talk of negative rates has spread to the US, with Fed Chairwoman Janet Yellen failing to “take them off the table” at a recent congressional hearing. With a background like this, it would seem highly unlikely that rates are about to experience a move to the upside.
What exactly are negative interest rates? Well, negative rates means that the lender pays the borrower for the privilege of lending money. Yes, you read that right. You lend money to an entity and will not earn any interest. In fact, you will get back less money than you lent when the bond matures, which is where the ‘negative’ part comes into play. History never looks like history when you’re living through it, but believe me, we are living through it. This is the first time in at least 5,000 years we have driven interest rates below zero (see The History of Interest Rates written by Sidney Homer and Richard Sylla if you’d like more detail on interest rate history since 3000 BC).
In the US, our average interest rate is under 2% and we have a 300% Debt to GDP ratio. This means that the economy needs to grow at 6% just to cover interest expenses. We have $19+ trillion in total debt and last year interest costs were $240 billion, which works out to a 1.32% blended rate. A move to just 3% from here would mean that total debt service would be $600 billion annually. The bottom line is that higher rates will put a serious drag on the economy due to much higher debt service costs, something the Fed does not want to see happen. The additional pain of rising rates is that bond holders would suffer large paper losses unless they held their bonds to maturity:
What this means is that a 1% move higher in the 10 year interest rate yield would cause the principle of a 10-year note to fall 8.7% in price and a 30-year bond to fall 19.2% in price. That’s a pretty big hit to a portfolio on a mark-to-market basis, which is what investors would see on their monthly statements.
Along these lines, it’s interesting to note how drastically things have changed from a portfolio construction point of view. This graphic below, from the Wall Street Journal, shows how investors looking for a 7.5% annual return – similar to what they were able to get in 1995 holding 100% bonds – have now been forced into a much riskier pool of assets with a much higher level of volatility and risk:
On the global front, we know that in Japan the Bank of Japan (BOJ) is printing Yen and buying ETFs and stocks in their market. Things are a little more absurd in Switzerland where the Swiss National Bank (SNB) is printing money and buying stocks in the US, to the tune of over $60 billion. This is their most recent filing per the SEC’s website:
When you look through their recent purchases, you can see that the top four stocks they bought (Apple, Exxon, Microsoft and J&J) each totaled OVER $1billion. Again, history never looks like history when you’re living through it.
So here we are in the third year of the “maybe we’ll raise rates again” game run by the Fed. This game has been in play since October 2015. This dollar chart (courtesy of stockcharts.com) shows how the dollar rallied in anticipation of a rate hiking cycle and has since traded sideways while awaiting more hikes from the Fed:
We are at another historic place with regard to the price of real assets (i.e. tangible assets like metals, corn, wheat, sugar) which are trading at record lows versus financials assets (stocks and bonds):
Gold, on the other hand has had a nice move higher, trading in almost perfect correlation with zero-coupon treasury bonds:
I am becoming more convinced that the Fed might raise rates one more time, probably in December, in an attempt to maintain some credibility. The markets will start to price this in as the final rate hike and start looking toward the next round of lowering rates and more money printing. The economy can’t handle higher rates and is struggling as it is even after 8 years of 0% rates and $4 trillion of money creation. The dollar should start to trade lower, but more importantly, I think that real assets, especially gold, silver, and most of the grain complex will begin to finally turn higher after being in a 4-year bear market.
Here are 5-year charts of coffee, wheat, livestock, sugar, corn and cotton (courtesy of stockcharts.com). The trend lower might have run its course and these commodities look to be bottoming and starting to work higher:
I will sign off noting that there was a really good Baron’s interview with MacroMavens’ Stephanie Pomboy this past weekend. The whole interview is worth reading, but I’ll leave you with my favorite quotes:
The statistics bear this out. Over the last four years, U.S. nominal GDP growth has gone from 4.3% to 4.1% to 3% to 2.4%. The deflator, the inflation we are supposed to be targeting, went from 1.9% to 1.6% to 1.5% to 1.1%. What greater proof do you need that lower rates aren’t helping and, to the contrary, are making things worse? Growth and inflation are slowing, and it has to do with this aging demographic. Add the emotional and financial scares from the housing-bubble bust, and policy makers have really got it ass-backwards. They’re taxing the economy, not stimulating it….
Clearly, QE [quantitative easing, in which a central bank like the Federal Reserve buys government bonds to lower interest rates and increase the money supply] isn’t doing the job. The markets anticipate another Fed rate hike. We never should have raised rates in the first place. The question is, how quickly do they reverse? More QE isn’t the solution. But policy makers aren’t ready to concede defeat. So, the Fed will abandon rate hikes and eventually re-up QE in some form. I do see helicopter money getting here, but that kind of fiscal stimulus has a substantially longer fuse. You’ve got to come up with a proposal, get everyone to agree, enact it, implement it. There will probably be some risk-off move that causes the Fed to panic and an interim QE attempt to calm the markets before we get that helicopter in the air…
The consensus is forecasting GDP to more than double in the second half, from 1% to roughly 2.5%. We are far more likely to stay in the 1% area or go lower…. The correction will drag down most of the market. We could easily go back to the 2009 lows. I could see 2017 being a pretty nasty year…. We’ll also have a renewal of QE in the U.S. and are seeing it elsewhere. And as Fed tightening goes out the window and the dollar sells off, we’ll have another meaningful leg up in gold.
Thanks for taking a look,
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