Topic/Theme Reports

Living In a Negative Yield, Material World?

Dr. Scott MacDonald

September 2, 2016

As the #1 female pop star of all-time, Madonna sang in the '80s, "we are living in a material world!!"! Yet it is hard to get the world's material desires fulfilled in a negative interest rate world! Madonna's sage reply to that was, "If they don't give me proper credit, I just walk away!" And the question remains to investors is whether they will run away from the stock & bond market bubbles driven by negative yields and whether it all ends spectacularly painful, yet again, yet again.   

Tradeweb recently estimated that negative-yielding bonds had risen to $13.4 trillion (helped along by the UK slipping into negative yield territory these past weeks).  Most of those bonds are from high-rated sovereign issuers, including Germany, Sweden, Switzerland and Japan.  The cause of this development is straightforward - central bank policies around the world are dominating markets by keeping monetary policy highly accommodative.  Consequently, sovereign debt and high-rated corporate bonds have become highly priced - into negative yields.

Bank of England Goes Down
In early August the Bank of England joined the ranks of central banks being more aggressive in terms of monetary policy.  The BOE revived its lapsed bond-buying program and cut its interest rate to 0.25%, which is the lowest level in more than three centuries. Prior to the Brexit vote, the BOE was expected to start raising rates. However, the victory of the Leave vote in June changed circumstances, with the BOE now seeking to reduce the negative impact of an economy slipping into recession. 

Asset Managers Parched For Yield
As sovereign bonds have reached into negative territory, the investment world is struggling to find yield.  Pension funds, insurance companies and mutual funds are finding the race to the bottom in terms of interest rates a significant problem as the demographic shift by baby boomer retirement is squeezing investment guidelines.  On the one side these investors have a responsibility to prudently manage money (i.e. don't lose it), while generating enough yield to provide a decent cash flow - hopefully to allow retirees to enjoy their "golden years".  Fat chance or should we say skinny days ahead chance?!?

Low-to-No Growth World, Fiscal Policy Not to the Rescue, Yet!
But things have not gone according to expectations.  The global economic recovery has been weak and uncertain since the Great Recession.  In response central banks have pursued low interest rate policies that have sought to pump markets up and make interest rates low enough to open the credit spigots and foster economic growth.  However, it is not working out that way.  A lack of confidence has made lenders cautious and businesses are reluctant to invest in capital spending.  At the same time, many governments, as in the United States, have opted not to conduct the usual fiscal policy because of partisan fighting or adopted tough austerity fiscal policies, as in much of Europe.  This has left the central bankers adopting more simulative interest rate policies, including negative rates.

Leading To Stock Market & Credit Market Bubbles? Yikes!
The result of this policy negative yield conundrum among central banks is captured by the Financial Times (August 12, 2016): "That has further squashed bond yields, and forced investors to scurry into emerging markets, junk bonds and ultra-long dated government debt to snap up what little remains of potential returns.  Money is also spilling into the global stock market, helping the FTSE All-World index to a 5.3 percent this year and pushing all three US equity indices to a 'trifecta" of fresh records this week."

At the end of the day, the upward trajectory of equity markets and bond markets is pushed by central bank policies, not by strong economic growth.  There is a significant gap between advanced country economic performance and where asset prices are.  In bond markets the shift to negative yields is not a positive development; when rates eventually go up - and they will - investors holding bonds purchased at a negative rate will take a large loss.  It is often said that bad things end in tears, which could well be the case here.