Why So Negative? Fixed Income Outlook
As more central banks turn to negative interest rates in an attempt to stoke inflation and stimulate growth, investors who need to generate income face increasing challenges. We hope that central bankers will someday admit (perhaps in their memoirs) that this hugely expensive experiment failed in its goals to drive investors and corporations to invest and stimulate the economy, but instead drove them deeper into a mentality of hoarding savings to compensate for the lack of earnings power on their cash. Such memoirs may also admit that the resulting asset inflation only widened the wealth-inequality rift. Partly to blame for these unintended outcomes is the fact that (contrary to central banks’ models) companies and savers have not moved out on the risk curve. In fact they have done the exact opposite: sought narrow money (aka cash). The $64 trillion question now is: Do central bankers continue on the same path or do they pull back and try to get out from the untenable position in which they have put themselves?
As we have discussed in prior outlooks, zero and negative interest rate policies (ZIRP and NIRP) are designed to increase consumer and business spending, given that the alternative returns on cash are low to negative. While this makes intuitive sense, so far holders of cash have concluded that a small loss and relative safety of principal is preferable to a possible larger loss on less certain investments. Additionally, as those without a guaranteed pension understand quite well, when cash earns less than nothing, it will take more of it to provide a comfortable retirement, so savings rates rise. Japan, which has suffered with a low interest rate for the past two decades and recently initiated NIRP, saw their savings rate rise from a long-term average of 11.7% to 46.1% in June of 2016. It has since declined a bit to “only” 27.4% in July. We suspect this may have more to do with their large population of retired people beginning to withdraw savings for living expenses than a sudden urge to invest and spend. Denmark, which introduced negative interest rates in July 2012, saw its household savings rate rise from its long-term average of 6.5% to a new high of 18.8% earlier this year. Obviously savers don’t yet realize that this behavior runs counter to central bankers’ models!
Under NIRP, not only are savers charged for their cash deposits held at banks, but the banks themselves are also charged for their excess deposits held at the central bank. This should be, in theory at least, an incentive for banks to lend that money out at higher rates, which should in turn stimulate growth. Currently, U.S. banks receive a 0.50% interest rate on their excess deposits held at the Federal Reserve (Fed). This relatively “high” rate may explain why bank excess deposits at the Fed, although declining somewhat from the peak in 2014, currently stand at approximately $2.5 trillion. By contrast, excess reserves at the Bank of Japan stand at approximately $235 billion and European Central Bank (ECB) excess reserves are about $638 billion at current exchange rates. Bank lending growth in Japan and Europe remain stuck in the 1-2% range. Gross Domestic Product (GDP) growth is, not surprisingly, also anemic in Japan and Europe. Switzerland, which introduced negative rates in January 2015, has since seen GDP growth below 1%, and their retail sales and inflation have also remained in negative territory. We think that any rational observer would likely conclude that while NIRP may be very effective at inflating asset prices, it has failed at stimulating spending and increasing economic activity.
The practice of economic targeting by the Fed needs to be addressed. Since our massive stimulus began, the Fed has steadfastly set a 2% inflation and a sub 5% unemployment target it would like to achieve before commencing interest rate normalization. We have written in the past about the Fed moving the goalposts as these targets are met. Both have basically been achieved recently; now the Fed has raised the possibility of a higher inflation target of 4% and is also emphasizing the employment participation rate, which has been stuck at low levels for years. This simply continues a pattern of foot dragging by the Fed by anchoring the markets around new goalposts while they inflate asset prices in hopes of the “wealth effect” finally taking hold. We believe that inflation targeting is not what it’s hyped up to be for a number of reasons. Conventional thinking is that if the Fed can somehow engineer higher inflation, then the debt load can somehow be magically inflated away. This is patently untrue and I’d like to thank Paul Donovan, UBS economist, for bringing to my attention the myths surrounding debt deflation. First, there is a large swath of government spending that is tied to inflation, such as welfare and social security. If inflation rises, the very cost of running the government also rises. Any rise in inflation will be offset by increases in government spending, which, as long as we’re running deficits, will be funded by more debt. Second, some portion of the Treasury debt outstanding is inflation-linked. This is true more so in the U.K. than in the U.S., but any inflation results in a concomitant increase in the principal outstanding of this debt. Third, there would be higher nominal debt servicing costs to refinance maturing debt, which will likely carry higher coupons as investors demand higher interest rates to compensate for higher inflation. There are also additional headwinds to inflating ourselves out of our debt, but you get the picture. This brings into question why inflation targeting is so important to the Fed. Certainly, lower prices are good for the consumer, generally speaking, but not good for those with debt, like the governments who have piled it on in an attempt to stimulate growth.
Fed Chairwoman Yellen’s message from Jackson Hole is that for now, the Fed is not contemplating negative interest rates because the U.S. economy is slowly improving and officials are looking to gradually raise rates from exceptionally low levels. Dennis Lockhart, president of the Federal Reserve Bank of Atlanta, said, “…I am treating this [negative rates] as an experiment that we have the luxury to watch from a distance.” We hope they are telling the truth as a NIRP would likely imply that we have reached the limits of monetary policy. On the other hand, if the Fed plowed ahead with negative interest rates, perhaps this could ultimately cause a crisis that politicians seem to need in order to shake them out of their lethargy and to finally pursue meaningful fiscal stimulus and structural reforms. The ECB has missed its inflation target for at least the past three years and has cut its quarterly Eurozone growth forecast for the next three years. As a result, the ECB President finally admitted that there are limits to what monetary policy can achieve, and urged Germany to boost spending to support the economy. Fed officials here have also gently prodded our leaders in Washington D.C. to enact fiscal stimulus, but it has largely fallen on deaf ears. We are encouraged to see that both presidential candidates are talking about expansionary fiscal policies; we hope it is more than campaign rhetoric. While we could debate the merits of each candidate’s tax, spending and reform plans, we’ll wait until after the election to ponder what’s possible since we will likely have continued partisan gridlock in Congress and large deficits to deal with as well.
Even though NIRP is currently not under consideration, interest rates in the U.S. continue to move lower. This is likely because as investors from countries with zero to negative interest rates search for better alternatives, demand for U.S. Treasuries is growing. This could drive yields even lower. Although we do not currently expect a recession any time soon, if an exogenous event meaningfully weakened the economy, the Fed may have no choice but to enter the netherworld that is NIRP given its lack of imagination and strict adherence to their models. Let us hope it doesn’t come to that.
As we stated in our last Investment Outlook, we still believe our economy is likely to remain in a slow growth and low interest rate environment for some time. If rates do indeed get pushed lower by the relentless search for “safe-haven” yields, then other markets, such as high yield bonds, may follow. Since shorter duration, high yield bonds currently offer meaningfully higher yields than Treasuries, a further boost caused by a rally in Treasuries accompanied by flat or even tighter spreads could have a further positive impact on total returns in high yield bonds. Given the possibility for higher market volatility going into the election and beyond, we are keeping our defensive, shorter-duration bias and maintaining ample liquidity. Hopefully we can take advantage of bouts of market weakness to acquire both convertible and high yield bonds at attractive yields.
As always, we thank you for your continued trust and welcome any questions and comments you may have.
© Osterweis Capital Management