Monday, 25 June 2018

Preparing for negative rates

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If you are not prepared for negative interest rates, you may have left it too late.

James Saft, Reuters Columnist

The European Central Bank on Thursday cut interest rates by 25bp to a record low 0.75%, and ECB chief Mario Draghi acknowledged afterward that actual negative interest rates are part of his arsenal.

Following suit shortly thereafter the Danish central bank cuts its own rates by 25bp, a move that took a secondary certificate of deposit rate to -0.20%. That’s right, some Danish savers will now be paying their central bank for the privilege of lending it money.

While many “real” interest rates have been negative for some time, investors are increasingly finding themselves faced with securities which, however safe, are essentially pay-to-hold.

This is far from being unprecedented. Germany already allows investors to bid negative yields for short-term government debt at auctions. In January, the Treasury Borrowing Advisory Committee, a group of Wall Street bond market participants, urged the U.S. Treasury to do the same.

In short, global interest rates are low and show every sign of grinding lower, perhaps even into negative territory.

The reasons why are as obvious as they are complicated. Europe is a mess and is sending waves of deflation globally as its weaker states struggle to regain competitiveness. This will either go on for a long time or end suddenly: with a huge burst of deflationary power if the currency area breaks apart.

China’s bubble looks to be deflating, and the US is in the midst of a very long process of paying back debt and cutting risk.

That this should be happening at the same time as some borrowers are being punished with very high rates of interest is not surprising. Spanish 10-year bond yields climbed to 6.78% after the ECB decision, rising by their most in a single trading session for almost 20 years.

That was partly because markets hoped the ECB would do even more to ease economic pain, but also for the very simple reason that, left as it is on its own, Spain (and many other borrowers) are very bad bets.

So rising rates for some are a symptom of the same underlying ill - debt deflation. Many borrowers can’t pay, and will default, and almost worse, many who can repay will, further stifling the debt-fuelled growth we enjoyed up to 2008.

What to do then?

Traditionally, very low rates should be a boon to equities. Low rates, as central bankers intend, encourage people to sell bonds and take on more risk for higher returns. Low rates also make today’s value of future earnings theoretically higher, something that many believe should drive an expansion of equity price/earnings multiples.

So far, neither of these drivers appear to be working. Investors continue to fear equities and flock to bonds, despite record low yields in safe instruments. And as for rising P/Es, corporate profits are at record highs in the U.S., but investors seem more concerned about how they will be sustained than what they are worth relative to very low Treasury yields.

That’s correct. There is no free lunch in investing, and record low yields are only a feature because we are in extraordinarily difficult economic times.

Conversely, these should be the worst of times for bonds, with seemingly extremely asymmetric risks. After all, even if you see rates going negative that simply can’t be a sustained state.

At a certain point central banks will react to deflation by printing enough money to make it stop. That is going to – eventually – play havoc with bond returns.

Still, the best way to look at low bond yields is to understand that the cost of safety is high because the value of safety is high.

Which, as always, brings us to the vexed question of gold.

Gold has had a bad year, and a standard explanation would be that its buyers are less concerned with inflation, or less confident in central banks’ commitment and ability to fight it.

Gold does, however, offer a kind of option value, protecting people who are worried that their home currency will be debased with a crude but sometimes valuable kind of insurance.

As ever, over-confidence is often deadly, and anyone who believes they understand with a high degree of certainty how this will work out is almost certainly deluded.

Hedge your bets, and be willing to pay up for keeping your options open.

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