Asset Management: Multi-Asset Insights

The strange world of negative interest rates

pendulum

Albert Einstein once said, “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” One has to wonder what Albert, having lived in Europe most of his life, would do with his savings were he alive today. As of this writing, 2-year government bond yields are actually negative in Germany, France, Sweden, Switzerland and the Netherlands. In an extremely rare corporate example, 4-year bonds issued by Swiss consumer products company Nestle1 have turned negative too. What type of buyer is willing to actually PAY an entity to borrow their money knowing full well that at maturity you get less than your initial principal back?

In many ways, we believe the negative yield phenomenon can be traced back to central bank policies. The European Central Bank (ECB) is charging banks to hold their surplus cash. When monetary policy results in negative deposit rates, buying bonds priced to deliver “less negative” rates is viewed as a better outcome. For those buyers expecting outright deflation in select debtor nations, it doesn’t seem so silly to own outstanding bond issues with negative yields. And don’t forget that owning bonds denominated in a currency that appreciates in value may more than offset any impact of a negative interest rate on returns. Look no further than the recent overnight 30% surge of the Swiss franc versus the euro as an extreme example of how bondholders can turn negative yields into positive outcomes.

The ECB is just beginning to implement its newly announced quantitative easing strategy. Part of this strategy entails buying an assortment of bonds, including government bonds that currently exhibit negative yields. This represents an ongoing source of price-insensitive demand that many believe will hold euro bond yields down for an extended period of time. Another source of price-insensitive demand comes from Eurobond and world bond index funds that have no choice but to mimic the composition of an index, no matter the initial purchase yields of component bonds.

What — if anything — should U.S.-based bond investors do now? One must be mindful of global yield correlations to make sense of ultra-low Treasury yields. There is an almost 90% correlation between the yield movement of a 10-year German bund and the 10-year U.S. Treasury note. With the yield of the German bund hovering near 35 basis points, U.S. bonds at 1.9% look downright cheap by comparison, especially if you believe the U.S. dollar will continue to strengthen. It appears that for long-term U.S. interest rates to rise significantly there would likely be some coincident rise in rate levels in other developed countries. Of course, if near zero inflation (or outright deflation) would persist over a long period of time, interest rates could stay lower for longer.

The Multi-Asset Solutions Team fully realizes that in the short term falling oil prices foretell benign inflation readings, but a tighter labor market could soon begin to create wage pressures, as it normally does in the second half of an expansion. By the end of 2016 or sooner, we believe inflation will likely be back in the vicinity of the Federal Reserve’s 2% target range. Inflation of 2% annually doesn’t sound too scary, but it exceeds the implied inflation rate of 1.7% which is currently priced into the market. To our way of thinking, a market that currently misprices future inflationary levels supports our modest underweight and shorter duration exposure to bonds across strategies.

 

1 For illustrative purposes only, not a recommendation to buy or sell any security.

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