Negative rates: why do they happen, what do they mean, and what can we do about it?
A core principle of financial theory is the time value of money - the idea that there is greater benefit to receiving money now than an identical sum in the future. Those of us running businesses understand well the critical nature of the timing of cash flow, but anyone can see that providing money can earn interest, money held today is more valuable than money due later.
So, what happens when rather than paying to borrow money today, borrowers can freely borrow and hand back less in the future? This question may seem strange and it is certainly unusual, but as of this writing, fifteen trillion dollars of debt trades with a negative yield; that’s about 30% of the global market. Creditors are paying to receive back less than they lend or, putting it another way, the issuers of debt are being paid to borrow. Five years ago, this was unheard of; this year alone, the amount of debt trading with a negative yield has doubled.
Why has this happened?
There are several reasons why this bizarre situation has arisen: pension funds must own bonds to match their liabilities; international investors care less about yield and more about currency, and therefore may invest even at negative rates in the expectation the currency in which they invest will appreciate relative to their own; and domestic investors may expect deflation – falling prices – in the context of which the value of their bonds will increase, irrespective of the yield at the time of purchase.
But the most important players in this perverse pantomime of economic affairs are the world’s central banks, whose policies of Quantitative Easing (QE) have distorted asset prices worldwide. QE is unconventional monetary activity whereby a central bank creates money with which to buy government and other bonds to lower interest rates and increase the money supply. The scale with which the monetary base in the United States has been increased via this method is immense, as illustrated below.
Creditors investing to achieve back less than their initial capital and depositors paying to leave money on deposit – inconceivable prior to 2008 - are stark illustrations of this peculiar activity but by no means its only symptom. The world’s benchmark equity index is trading at an all-time high, irrespective of the precarious economic backdrop, and gold bullion has awoken from its slumber.
What does all this mean?
This means several things: people are worried about the future of the world economy and happily will accept a negative return, believing return of capital to be more decisive than return on capital; some see no value in the bond markets whatsoever and would far rather put their money into shares, where at least they can receive an income (the FTSE 100 yields around 5%) and, if history is a guide, healthy capital gains on top.
Others are rapidly losing confidence in fiat currency altogether and would much rather own a tangible medium of exchange such as a gold bar, which yields nothing but will continue to exist and be worth something in 50 years, which is more than one can say for cash on deposit.
What should we do about it?
What we should do about all of this rather depends on our respective situations. Great pressures are at work to ensure asset prices do not provide the signals they ordinarily would under more normal conditions. Interest rates at the Bank of England were cut sharply in the aftermath of the bankruptcy of Lehman Brothers and the ensuing chaos to the lowest level since the Bank was founded in 1694.
The persistence of these emergency rates ten years on from that period of crisis is extraordinary; and the United Kingdom is far from being alone, with the Federal Reserve having recently cut rates twice in as many months and the European Central Bank having announced it is to embark on yet more QE, beginning this November. This is unprecedented.
If the global economy may be likened to a person, she ran the Boston marathon in 2007, went into a coma in 2008, and remains on life support in 2019. In short, the situation is precarious. To understand why central bankers act this way, look at Japan. The resolution of the debt problems there in the 1990s was painfully slow and monetary policy was not sufficiently easy to push nominal growth above nominal interest rates for more than twenty years. The Japanese economy fell into a deflationary spiral and it was not until 2013 that it eventually emerged; meanwhile the Japanese stock market today trades more than 40% below its peak of December 1989.
The Danish physicist Niels Bohr said: “it is difficult to predict, especially the future,” to which J K Galbraith added, “the only function of economic forecasting is to make astrology look respectable,” so forgive me for not making any forecasts here (you should thank me). Let us simply observe that the powers that be are determined to do whatever is necessary to avoid a Japanese-style deflation. The consequence is asset prices rising as monetary debasement stimulates inflation.
We have never seen monetary inflation on the scale it is being practised today, so it is impossible to fathom the extent to which asset prices will be affected over the long run; gold’s recent move may prove modest.
Given this unconventional environment, one activity that does make sense, we will all be pleased to hear, is to continue with our activities in property. The property market, particularly the London property market, offers yields above cash and bonds, preservation of capital in real terms (i.e. after allowing for inflation), and, following the recent fall in sterling, is of great interest to international investors.
For funds not required in your day-to-day business activities, the money markets offer a short-term solution preferable to the banks (US Treasury Bills yield 1.8%), while far better value can be had by investing into businesses where share prices discount a future so bleak, they offer a substantial margin of safety. Many companies around the world fit that description, particularly some UK midcaps, tarred with a Brexit brush that bears barely any relevance to their operations.
Diversifying that portfolio with a sprinkling of gold bullion may well reap handsome rewards, given time. Meanwhile, those money market reserves will be very useful during the next bear market, if ever it is permitted. The stock market is a device for transferring money from the impatient to the patient and vast sums have been lost reaching for yield. Now is the time for patience.
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