Season Investments



Posted on July 26, 2016

“Now, I am not suggesting the Fed will push rates negative this month or even this year – but they will do it eventually.” – John Mauldin

2016-07-26_nirp.jpgWhat if I asked you for a loan, say $1,000, and offered to pay you back with interest over the next ten years? Let’s assume I’m a good credit risk (I am), and you had relative certainty that you could trust me to fulfill my end of the bargain (you could). Now let’s assume I offered to really make it worth your while by paying you a handsome interest rate of -0.52% per year! Would you take that deal? Would you give me $1,000 today for the opportunity to receive back less than $950 over the next ten years? No, of course you wouldn’t. But plenty of “investors” all over the world are accepting that deal even as we speak.

Our very own Federal Reserve is in session this week. The market widely expects the Fed to stand pat on their benchmark interest rate, but odds are increasing for another rate hike at some point later this year. If a hike does come it will be the second one (the first came late last year) since interest rates were dropped to zero amidst the throws of the financial crisis. Zero Interest Rate Policy, or “ZIRP”, has been the norm in recent years from the dominant central banks of the US, Europe and Japan. Remember, central bankers exercise direct control over short-term interbank lending rates which act as base rates for everything else, so when we talk about zero interest rates we’re typically referring to the overnight lending rate within the banking system. (See Fed Ed: Pulling Back The Curtain for more discussion on the nuts and bolts of central bank operations.)

Zero interest rates are intended to induce growth in borrowing, lending and general risk taking throughout the economy. But what happens when ZIRP doesn’t have its intended effect on economic activity? You move to the next logical extreme: NIRP. That’s right…Negative Interest Rate Policy.

Even as US policy makers are inching ever so slowing away from the zero bound, the Europeans and Japanese are doing the same, but in the opposite direction! In an effort to encourage their respective banking systems to initiate more loans both the ECB and BOJ have instated a negative interest rate of -0.10% on reserves parked at the central bank. So rather than earning positive interest, banks must now pay the central bank a penalty for holding liquid reserves!

The ECB’s website explains the intention behind such a move in relatively straightforward language:

By reducing interest rates and thus making it less attractive for people to save and more attractive to borrow, the central bank encourages people to spend money or invest.

As we mentioned, the US is not currently in the NIRP camp. But what will happen if something tips our economy into recession? Where can the Fed go from here if it wants to play a role in stimulating economic activity? As John Mauldin eludes to in the opening quote, many analysts believe it’s only a matter of time before the US follows the lead of Europe and Japan into negative interest rate territory.

What’s perhaps more amazing than a negative interest rate on bank reserves is the fact that many pockets of the bond market have also turned negative. In fact, according to Fitch Ratings there is now $10 trillion worth of sovereign debt trading at negative yields. This represents over 25% of the JP Morgan Global Government Bond Index. Think back to the proposed scenario I put forth in the first paragraph…this is exactly the deal that bond buyers the world over are accepting when they buy these securities.

Switzerland is a fantastic case in point. As the chart below shows, the entire Swiss yield curve is now trading at negative yields! Note that the Swiss 10-year bond yield is at -0.52%, the rate I used for my example at the beginning of this post.


So how does something like this happen? It’s one thing for a central bank to manipulate the rate paid on reserves, but what could possibly explain an investor accepting a negative yield on a government bond of any maturity? There are a handful of possible explanations…

  • Central bank buying. The central banks of the world have become the largest source of demand for government securities. The ECB and BOJ in particular are formally committed to buying up substantial amounts of government debt in their respective regions. These buyers are not necessarily sensitive to the yield they are locking in…and in fact the whole point of their purchases is to manipulate yields lower.
  • Deflation. The quoted interest rates as we typically discuss them are referred to as “nominal” rates, while subtracting inflation from those rates gives us what are called “real” rates. If the marketplace expects deflation (negative inflation), it’s feasible that a bond trading at a negative nominal yield could still offer up a positive real yield. Even in that scenario, however, it would make more sense to simply hold cash rather than investing in a security with a negative yield.
  • Currency expectations. It might be worth it for a foreign investor to put money into a negative yielding security if they anticipate currency movements to more than compensate them for that loss. This is largely what explains what is going on with Swiss bonds. The Swiss Franc is widely expected to outperform the Euro, and a flood of money from Euro-denominated investors has pushed yields to the levels reflected on the above chart. As long as the Franc appreciates against the Euro by an adequate amount, the investor will still realize a positive return.
  • Indexed money. A lot of investment capital is invested in index funds these days. If a global bond index manager receives inflows into his fund, he will allocate that capital pro-rata across the securities that make up the index he is mandated to track. This money isn’t sensitive to what those securities are yielding, only that they appear in the relevant index.
  • Greater fool theory. As bond prices rise yields drop. This means that the journey that has taken bond yields from positive to negative territory has coincided with a nice amount of price appreciation for those that have held the securities throughout. Speculators will join the bandwagon in anticipated of even more negative yields and additional price appreciation. Surely there will be a greater fool who will buy the bond at a later date for an even higher price, right?

Regardless of what combination of the above factors accounts for the current situation, it’s clear that central bank group think is at the root of what is going on. There are all sorts of distortions that were created by ZIRP and are now being exacerbated by NIRP, not the least of which is the incentive for investors to take greater and greater risk in their hunt for yield. As Deutsche Bank’s chief economist David Fokerts-Landau quipped in a recent research note:

Already it is clear that lower and lower interest rates and ever larger purchases are confronting the law of decreasing returns. …But the ECB’s response is to push policy to further extremes. This causes mis-allocations in the real economy that become increasingly hard to reverse without even greater pain. …Thereby ECB policy is threatening the European project as a whole for the sake of short-term financial stability. The benefits from ever-looser policy are diminishing while the litany of distortions, perversions and disincentives grows by the day. Savers are punished and speculators rewarded.

As money managers we are faced with the tensions created by overly involved policy makers on a daily basis. Risk taking has been rewarded moderately in recent years, but to what extent have gains been artificially inflated? The struggle is especially real for older investors focused on preservation and income. It is simply impossible to generate much yield in today’s markets without feeling like certain risk boundaries are being violated. That said, there are still opportunities to be found for those willing to look far and wide and leave no stone unturned, and there are also ways to participate in risky stock and hard asset markets without leaving yourself fully exposed to the next major collapse. Our clients are aware of and have benefited from many such examples. At Season Investments our approach has always rested solidly on a foundation of true diversification and proactive risk management. In a world where NIRP Is The New ZIRP we’re confident this foundation is more important than ever.

david_headshot_bw.jpgAuthor David Houle, CFA is a founding member of Season Investments. He serves as the firm's Chief Compliance Officer as well as sitting on the investment committee overseeing the management of client assets. David spent nearly ten years in various roles primarily managing individual client assets prior to co-founding Season Investments. David graduated with a degree in Finance from Colorado University in Colorado Springs in 2003 and earned the Chartered Financial Analyst (CFA) designation in 2006. David and his wife Mandy have three children and spend most of their free time with friends and family.

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