September 27, 2019
We are truly living in interesting times. It’s hard to believe that since the first glimmer of sub-zero rates in 2014, now 40% of global developed market government bonds have negative yields, which means that at the bond’s maturity, investors will get back less than they paid. That’s $17 trillion across 19 countries, for those of you keeping track.
Now, you may be thinking, “That just doesn’t make any sense. Who would buy all those negative yielding bonds?” Well, for one, investors who believe that rates are headed even lower are speculating that lower rates will drive bond prices higher, which could actually mean a profit. There are also forced buyers, like pension funds and financial institutions, who have no choice because they are required to own certain types of high-quality assets. There are also central banks. For instance, the Bank of Japan owns nearly half of Japan’s government debt while the European Central Bank (ECB) owns more than 20% of its own government debt. Just this month, the ECB announced that they were extending their bond buying indefinitely and cutting their baseline interest rate by another -0.10% into negative territory — taking their key interest rate to -0.50%. So it looks like that direction isn’t going to reverse anytime soon.
The low interest rates abroad are starting to affect U.S. policy. Global investors seeking a higher yield and safety have bought U.S. bonds, which has contributed to a stronger U.S. dollar. However, because the U.S. dollar is involved in so many global transactions, a stronger dollar tightens global financial conditions and slows economic growth. This has concerned U.S. policymakers. The Fed, on a march to normalize (raise) interest rates as recently as a year ago, has since reversed their position and begun cutting rates, and markets expect them to lower interest rates even more this year.
Will this cause interest rates to head below zero here in the U.S.? While we can’t predict what the future holds, we would place a much lower probability of negative rates happening here. Why? Europe is administering one monetary policy in the context of many different and independent fiscal policies. Imagine trying to balance Italy and Germany with one interest rate. This is not a challenge we face domestically. Also, the U.S. is experiencing higher inflation and productivity, particularly in the services sector. This argues for higher, not lower rates. And then there’s the question of whether negative interest rates will even be effective ultimately. We have our own doubts about that.
A key part of our view on interest rates rests with the understanding that negative yields are not a naturally occurring phenomenon. They are manmade and the result of extraordinary monetary policy. Global growth has struggled since the 2008 financial crisis. European banks haven’t lent out their excess reserves because of a lack of demand, so the central bank is trying to punish banks that don’t lend more and trying to encourage consumers to spend. But it hasn’t worked.
If negative yields are abnormal, then their effects are likely to be abnormal as well. We believe such unsound policies distort economic incentives. Negative rates harm the banking system and impair capital investment and, therefore, economic growth. They encourage risk taking, as savers have no choice but to reach for yield in unsafe places. Financial models don’t know how to account for negative yields.
Interest rates are the baseline pricing for all assets, including stocks. With a distorted rate, stock prices have been higher, and disciplined investors who care about the price they pay for investments end up looking out of touch because they refuse to pay market prices. Low interest rates have already left many investors scratching their heads and led them to abandon value investing in pursuit of momentum-type strategies; it’s easier to follow the market than to ascertain how policymakers will intervene in market prices. Negative rates only exacerbate the price-value disconnect.
We believe that negative yields are ineffective and unsustainable. The question is, will policymakers have the courage to normalize interest rates or will they push financial markets to their breaking points? So far, reconciliation is delayed and global debt levels continue to increase as policymakers opt to bolster near-term consumer sentiment at the expense of long-term growth.
No one knows how long this can go on. But a much longer leash has been extended since policymakers took the debt load from the private sector, which reached its practical debt limits in the financial crisis. That was more than 10 years ago now, and many investors speculate that central banks are reaching their policy limits. In the next downturn, governments will likely turn to fiscal policies such as spending and tax cuts to stimulate growth, which can carry risks of their own.
While this commentary has focused on negative interest rate policies, we don’t want to discourage investors. While the future is uncertain and unpredictable, let’s not finalize our conclusions just yet. On the positive side, our generation is experiencing some of the greatest innovations of recent times — in medicine, artificial intelligence, robotics, etc. — that could boost productivity and growth in some very pleasant and unexpected ways.
Investors should keep the bigger picture view in mind, not a short-term perspective. Opportunities to invest exist and will continue to surface for investors, which will likely help them increase the probability of meeting their long-term goals. To take advantage of these opportunities, investors should (1) know their goals and stay laser-focused on them, (2) know how they define success, (3) understand why they’re invested the way they are, (4) be vigilant, and (5) stay diversified. We believe those are the keys to investors navigating future investment environments successfully.