Issue 105 – April 1, 2016
Global Interest Rates – Less Than Zero
The first quarter of 2016 witnessed an extraordinary level of global
market volatility. The New Year immediately greeted equity investors with a
wave of profit taking followed by a tsunami of concerns surrounding slowing
Chinese GDP, aggressive US interest rate policy, and the inability of global
oil markets to find a pricing floor. Additional interest rate cuts coming
first from Japan and followed by the ECB were intended to provide additional
support for equity markets. Paradoxically, they had the opposite effect.
Negative interest rates, which were first seen in late 2014 and which had
been viewed as a gimmick at that time, now appear to have gained the status
of a 21st century policy tool. By the middle of February, credit spreads had
reached post crisis highs and equity markets were priced for a full-fledged
recession with the S&P down a full 10%. This was not what the Federal
Reserve had in mind when they moved off their own zero interest rate bound in
Mid-December with hopes for further increases to come.
Volatility was the biggest performer in the early part of 2016 with
the “VIX” (the CBOE volatility index of the S&P) spiking to levels last
seen during the summer of 2011 when the US debt rating was downgraded and
ongoing threats of government shutdowns loomed. We have noted in previous
letters that we did expect to see modestly increased levels of price
volatility due to several structural factors including historically low
interest rates, the increase in the trading of exchange traded funds (ETF’s)
of all flavors, and the diminished market making capabilities that resulted
from banks being prohibited to trade securities for their own accounts.
However, the S&P was moving in increments of 1-2% per day! Volatility of
this magnitude could not be blamed on marginal factors. Rick Reider of
Blackrock noted that since the market turbulence of last August, pundits have
tried unsuccessfully to lay the blame on one single headline or another. This
simplistic approach, in his opinion, continues to miss what he defines as the
driving market factors of this time - technology and demographic changes.
These are epic structural forces that will have far more lasting impact on
long term investing results than the day to day headlines.
As the quarter moved forward, value investors in both stocks and bonds were rewarded for their discriminating purchases at what were clearly oversold levels. Concerns over China coming to a full economic stop abated and markets repriced expectations over the path of the Federal Reserve to reflect much more modest increases for 2016. Oil prices briefly touched $26 in February but quickly recovered to the high $30’s on the strength of both anticipated production coordination among the major state owned producers along with the understanding that hefty amounts of future global production had been shelved due to lack of economic viability. The net of all of this activity and turbulence was to have an essentially flat quarter.
In This Edition
Global Interest Rates – Less Than Zero
What the Heck is N.I.R.P.?
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What the Heck is N.I.R.P.?
The short answer is “Negative Interest Rate Policy”. The longer answer
is messy. Consider that in the long history of the lender-borrower
relationship, there has never been a case for the widespread use of negative
rates. We have certainly seen over the past few decades the odd case of a
short term US Treasury bill trading at -0.01% over the year or quarter end.
This was a very short term supply and demand anomaly not a central bank
policy initiative. However, since the crisis of 2008, central bankers have gone
through a series of unconventional initiatives in their efforts to first
stabilize the financial system and then to assist in stimulating economic
activity. Beginning with Z.I.R.P., the zero rate policy and followed by a
series of QE or quantitative easing programs, the US Federal Reserve
established a beach head for capital markets to restore traditional functions
of debt and equity raising. In late 2014, after numerous iterations of QE,
the committee determined that further open market purchases of US Treasuries
were no longer having a discernable stimulative effect and they concluded
those operations while leaving the zero rate policy in place. Speculation
abounded throughout 2015 as to the timing of when the zero rate policy would
be retired and interest rates rose across all maturities. While the
effectiveness of the extended use of these unconventional monetary policies
will long be debated, we would argue that the policies were unambiguously
effective at the time when the financial system was most fragile.
One of the hallmarks of global central bank policy beginning in 2012
was their coordination in pursuing policies designed to dramatically ease
local credit conditions. This “pulling in the same direction” concluded in
2015 when the US Federal Reserve began laying the ground work to begin
normalizing (raising) interest rates. By contrast, Japan’s 2015 policy
continued moving enthusiastically in the opposite direction employing massive
QE operations. In addition, the European Central Bank also continued with
their own unconventional programs following Mario Draghi’s now famous promise
to “do whatever it takes” to stimulate the Eurozone economies. Traditionally,
the US Federal Reserve would not have concerned itself with the individual
policies of other central banks. Their dual mandate calls for a policy which
promotes full US employment and an inflation target of roughly 2%. However,
as soon as it became clear that the US policy was potentially getting ready
to move in the opposite direction of everyone else, the US dollar soared.
From the summer of 2014 to the summer of 2015, the Euro/$ exchange moved from
€1.35 to €1.13 making US export goods 16% more expensive than the previous
year. Who needs a Federal Reserve to tighten credit conditions when the
currency movements can do all your work for you? The committee grappled with
this dilemma as well as the practical mechanics of changing direction
throughout the year before coming to the conclusion that they could move the
benchmark rate to 0.25% at their December meeting.
Mohammed El-Erian, the former CEO of Pimco, has recently written a
book titled “The Only Game in Town” through which he articulates concerns
that central bankers have been asked in this post crisis period to tackle
problems for which they do not have either appropriate or sufficient tools.
Meanwhile, fiscal policy alternatives have been utterly absent. Further, he
notes that unconventional monetary methods will almost certainly have
unintended financial consequences. These unconventional monetary methods
would never be intended for long term use if for no other reason than that
these policies will have practical limits to their effectiveness just as we
saw in the US with our own use of QE. But what can a central banker do when
interest rates are at the zero bound and you have exhausted the limits of
stimulative effectiveness of any QE? You go negative…..
In late January, the Bank of Japan announced that they would push
their benchmark short term rate to -0.10% in an effort to further incentivize
investment and consumption. The simple idea is that if the commercial banks
are required to pay the central bank to hold their cash on deposit, a penalty
if you will, then they are more likely to lend and put more cash into their
system for constructive purposes. The central bankers argue that a negative
interest rate is just another number that just happens to be less than zero
and they inherently believe that there is a linear benefit from ever lower
rates. Market participants however disagreed and reacted poorly to this step
by taking the value of the yen from ¥120/$ to ¥112/$ as the policy rolled
out. The strengthening of the Yen was the last thing the Japan central bank
wanted or frankly expected to happen. Their presumption that the “expenses”
associated with further decreases in interest rates to a level below zero
would be easily passed along to depositors and bondholders was misguided on a
number of fronts.
To begin, consider that banks are well aware that if they were to
charge large depositors anything beyond a nominal fee for holding cash, then
those depositors would simply take their cash out of their bank. This reality
underpins the recent discussions among pundits on the need/opportunity to get
rid of physical cash. Paper money can be horded and put under the proverbial
“mattress”, while a digital currency presumably could not. Most recent
arguments in favor of ending cash have been “packaged” to address money
laundering etc. and have been coming from economists rather than law enforcement.
Make no mistake about it, “Bitcoin”, would pose numerous enforcement
challenges for those policing illicit money flows, but it would be a nifty
way to inflict negative interest rates on large depositors. If monetary
authorities really want to pursue a policy of long term use of negative
interest rates, including levels well below today’s, then they are going to
have to figure out a way to rid the world of physical cash.
The next puzzle concerns the matter of interest payments. Bond markets
are not mechanically set up to collect interest from bondholders. They are
set up to pay interest to the bondholders. As a practical matter, negative
rates on sovereign debt have been implemented through the use of a zero
coupon bonds trading above par. No interest changes hands and the bonds trade
based on their dollar price. For another brain teaser, consider the turmoil
that negative rates would create in a mortgage market when floating rate
borrowers could be expecting to have their interest paid for, at least in
part, by the bank or mortgage holder! Who is responsible for collecting
interest from the lender and paying to the borrower? How would that be
implemented? To put it mildly, this negative interest rate regime places
extraordinary stresses on the financial system.
Finally, negative rates are not just ultra-low interest rates. The
move below zero changes the nature of the credit relationship between a
lender and borrower. What, for example, is the credit rating of a Japanese
government bond when it is a pool of bondholders who are on the hook for the
repayment of interest rather than the Japanese government? Whatever rating you might settle upon, it
is not the full faith and credit of the government. It is something less.
Negative interest rates are not just numbers trading at levels less than
zero, they are re-writing the nature of fixed income in ways that are hard to
understand and impossible to manage. Despite all these practical
difficulties, some 30% of all global government bonds now trade at a rate
less than zero with the majority of these bonds coming from Japan. The recent
paradoxical currency performance makes more sense when you realize that the
Japanese consumer is no longer receiving virtually any bond income and there
is no penalty or opportunity cost for holding cash. Collectively, these
recent unconventional policies have stoked well-earned fears of a worsening
deflation spiral and Japanese consumers are responding rationally by holding
on to more and more cash. Those in the Eurozone have not experienced the same
level of deflationary feedback to date despite negative interest rates in
both Switzerland and Germany as those countries have relatively modest
amounts of Government debt relative to Japan. In the short term the ECB will
continue to have their hands full with their own efforts to stimulate growth.
Back here at home, negative interest rates should be off the table and the trajectory toward higher rates remains shallow. As Janet Yellen noted in her most recent FOMC press conference, much has already been accomplished with regard to bank capital, supervision, credit quality, and liquidity. Translation, there is not much more that monetary policy can do for this cycle. She reinforced these views in her address to the Economic Club of New York on March 29th where she conceded that “global” concerns have increased risks to growth since the December meeting. The question now turns to the matter of economic resilience and to how markets can build upon the mid-winter recovery. The Federal Reserve, for its part, will therefore be a spectator for much of 2016.
We recently had the opportunity to hear Jim Paulsen, the Chief
Investment Strategist of Wells Fargo’s Capital Management division, present a
market update. Jim is a frequent speaker on radio and TV and is well worth a
listen. He comes to his forecasts from a macroeconomic perspective and has a
style which is very easy to listen to. His term for what lies ahead is for
neither a bull nor a bear market but a “Bunny” market which undulates or hops
from modest gains to modest consolidations. This would not be the market
where asset values were propelled by a rising tide of QE, but one that
rewards individual corporate excellence and execution. It is also a scenario
which very much favors a long term investing view.
As a “macro” guy, Jim believes in the veracity of the economic data. A point of disagreement we would have with his presentation is in regards to his discussion of declining “productivity”. Paulsen, along with numerous well respected strategists, point to a massive slowdown in Labor Productivity Growth across the globe. Could economic output per hour worked have really declined?
This slowdown, if something other than a measurement issue, would have
meaningful negative implications for corporate profits and GDP. However, as
we noted in our September newsletter, the work of Google and Stanford
economists tell a dramatically different and optimistic story.
When we consider that only those goods and services which are “sold” are counted, we can appreciate how a 1970’s concept would fail to capture important economic activity 40 years later. This empathy however does not make the spurious productivity data correct or meaningful. Software upgrades, enhancements and Apps do not budge the old productivity measurement no matter how much it improves our work output. Technology has become less of something we discreetly purchase episodically and more of something we use, constantly and ubiquitously. This understanding ties tightly into what we noted Rick Reider of Blackrock has been saying: technology is transforming our economy. Just ask any retailer or legacy energy company. The point of this is to say that as investors, in this era, where technology is remaking industries and consumer habits, we will certainly have opportunities to be successful. It will require patience and a certain amount of stubbornness, call it the “courage of our convictions”. The first quarter of 2016 was a text book lesson in this regard.
Jen & Patsy