Global economic growth has been slowing, uncertainty growing. Investors looking for safety and reduced volatility have been big buyers of the highest-quality debt, driving yields ever lower. As a consequence, the world’s cache of government bonds trading at negative yields has soared. Eric Lascelles, chief economist for RBC Global Asset Management Inc., digs into what’s driving this phenomenon and looks at how the persistence of negative rates might change investor behaviour and risk exposure.
How pervasive are negative interest rates and why are interest rates so low?
As much as $17 trillion of global debt has traded at a negative interest rate in 2019.
Eurozone and Japanese central bank policy rates are now themselves negative. This means that negative yields aren’t just a distortion of the market but something that is sanctioned by the highest-level policymakers.
Very low and negative interest rates principally reflect a slow real growth environment, and low, relatively stable inflation due to an aging population as well as the pervasive forces of globalization and automation.
But there are other reasons as well. Despite elevated government debt loads, there is arguably a shortage of “safe” debt in the world. As the pool of emerging market wealth expands, savers are crowding into the same developed world debt markets as everyone else since there are few AAA- or AA-rated investment opportunities in their own markets.
The share of bonds with negative yields has surged
Percentage of bonds in Bloomberg Barclays Global Aggregate Bond Index trading at negative yields
Source - RBC Global Asset Management, Bloomberg; data through 10/25/19
Central banks also artificially restrain short-term rates to keep borrowing costs affordable for heavily indebted economies. This is counterintuitive as one would naturally assume that high debt levels would push borrowing costs higher as a risk premium is embedded.
U.S. nominal GDP and 10-year yield in tandem
Source - RBC Global Asset Management, Bureau of Economic Analysis (BEA), Federal Reserve Board, Macrobond; five-year moving average of year-over-year nominal GDP growth through Q2 2019; yield data through 9/30/19
Lastly, in addition to this long list of structural depressants, there are also some downward cyclical pressures on bond yields given the lateness of the business cycle and easing central banks. This isn’t a permanent condition, but it is helping to keep yields toward the lower end of their new normal range.
How do savers, both individuals and corporations, change their behaviour in a world of low and negative interest rates?
Basically, the way individuals and corporations invest, use cash, and save are all likely to be modified by this environment.
Low interest rates can push savers outside of their comfort zones and into taking larger investment risks in an effort to secure some sort of return, or at least to avoid locking in guaranteed (albeit small) losses. Accordingly, they can become more vulnerable to periods of financial market volatility. Larger investment risks bring not only the possibility of substantial unanticipated losses, but also of diminished liquidity. This reduces the resilience of corporations and retirees alike to economic shocks.
Negative interest rates also encourage individuals and businesses to rely upon cash to a greater extent, rather than suffer losses in a bank account or the bond market. This, in turn, threatens to reduce tax compliance, compromise government tax revenues, and increase the incidence of loss through theft.
Other than using cash more, businesses and individuals who are confronted with negative rates are also incented to prepay invoices so that the negative return becomes the problem of the vendor they are buying from, and to prepay their income tax bill as a means of getting a guaranteed zero percent rate of return from the government, or even to overpay credit cards. All of these actions distort the economic system in various ways.
Perversely, households may also feel compelled to save more rather than less if they are to achieve their retirement objectives in a low-return world. This runs counter to central banks’ attempts to stimulate growth by cutting interest rates to encourage less saving and more spending. Households under pressure to save more is probably not sufficient to completely undermine the stimulative effects of low rates, but it is at least partially offsetting central bank efforts.
How about investors and pension funds in particular?
Among investors, pension funds are set to be particularly affected to the extent they have traditionally maintained low-risk, fixed-income-heavy portfolios that are designed to match the stable stream of payouts expected by their retirees. Those that stick with this approach are increasingly having to accept the prospect of diminished future returns and accordingly increasing contribution rates and/or cutting retiree benefits. Others are opting to venture further out the risk spectrum, achieving better returns but at the expense of greater volatility and risk.
And what of borrowers’ behaviour?
When borrowing costs are zero or even negative, then the necessary expected return on a new business project doesn’t have to be high. In fact, it can be as little as zero percent. As a result, some bad ideas are able to attract capital and be put into practice. This can eventually damage an economy’s productivity growth.
Borrowing naturally rises when the cost of servicing debt is extremely low. All of this extra leverage can eventually create problems, particularly were interest rates ever to rebound.
We often hear that the banking system is stressed by negative rates—how so?
Banks are classically hurt by negative interest rates as their excess reserves no longer earn a return, and their net interest margins (basically how much they earn on loans minus how much they pay out to depositors) shrink. Having said that, the health of the banking system is generally better than during the last recession, with higher levels of capitalization in particular.
Are low and negative rates good for the economy overall?
Central banks are cutting rates with the intent of boosting growth via the inducement to save less and spend more. But structurally low interest rates also limit the ability of monetary stimulus to further rescue economies when they run into trouble. In turn, recessions could become more frequent or more severe.
Moreover, the aforementioned behavioural distortions for savers and borrowers alike can create fragility within the economic system, and increase the risk of a financial crisis.
And what are the implications on financial markets of low and negative rates?
Returns in the fixed income market are unavoidably low in this environment, though rates continuing to edge lower can at least provide some capital gains along the way.
As the search for yield carries on, the valuations of other asset classes increase. This means that credit spreads should be unusually narrow and the price-to-earnings ratios that equities trade at should—in theory, at least—be unusually high.
This might initially be a profitable experience for those asset classes as they seek out their new levels, but ultimately the steady-state rate of return should diminish once the situation is fully priced in.
How long can we expect these very low rates?
History shows that the 1970s and 1980s were an extreme outlier to the topside for rates, and furthermore that there are multi-decade periods of time over which very low interest rates can persist. The current episode is particularly extreme in its depth, but not yet in its length. The bond market is not necessarily overdue to rebound to significantly higher levels.
Historical 10-year U.S. Treasury yields
Source - RBC Capital Markets, RBC Global Asset Management; data through 10/16/19
Who would buy a negative-yielding bond?
A surprising variety of investors are willing to tolerate a negative nominal interest rate. This shouldn’t be such a surprise since many have long put up with a negative return once inflation has been subtracted from the rate they are receiving, and for even longer when also adjusted for taxes paid.
Those are the thresholds that truly matter for people making investment decisions—in comparison, a negative nominal yield like we are seeing today is a fairly arbitrary development.
Some tactical investors expect bond yields to fall further, and so they seek to profit from the appreciation of the bond’s price to an extent that outweighs the steady drag of a negative coupon.
Others are able to convert a negative-yielding bond in a foreign market into a positive return in domestic terms by hedging out the currency risk under certain conditions. (One’s home market must have the higher short-term interest rate of the two, and the foreign market must have the steeper yield curve of the two. These conditions are presently fulfilled for North American investors buying negative-yielding European bonds, meaning that a positive return on these products is still achievable.)
Keep in mind that not all investors are sensitive to the expected return of a bond. The European Central Bank has purchased many European sovereign bonds with the intent of helping to depress interest rates as opposed to profit from them, and is unlikely to sell given the challenging economic environment. Commercial banks are generally obliged to keep much of their capital in safe and liquid investments like government bonds; if the return on these bonds is negative, it is unfortunate but can’t be helped. Foreign reserve managers are similarly obliged to hold safe, liquid, and usually short-term debt of foreign nations with an eye toward managing their exchange rate, not achieving a positive return.
Other investors are sensitive to their expected return, but cannot adjust quickly or at all. As an example, an institutional investor might be mandated to hold only AAA-rated European securities in a portfolio. Something else cannot be bought unless the mandate changes—an involved process. Similarly, a pension fund may be unwilling to tolerate the risk necessary to buy higher-yielding bonds, and so it is stuck with a negative return.
Why wouldn’t investors grappling with the prospect of a negative return simply keep their money in cash, or put it in a chequing account?
Those are not risk-free propositions, unlike a sovereign bond. Cash can be lost, destroyed, or stolen. A chequing account in developed countries is generally quite safe and provides deposit insurance, but this may not be sufficient, say, for a European corporation with far more money than deposit insurance can cover, and given the degree of upheaval in the European banking sector over the past 11 years.
So it sounds like the “lower-for-longer” interest rate environment could be here for some time, that the behaviours of individuals and businesses are adapting to this new environment and that some distortions in the economic landscape may start to appear as a result …
That is right. The current economic cycle may be extended thanks to central banks’ actions, but it may also eventually become marginally more fragile as a result of these policies. We have been pointing out for some time that we are firmly in the late stage of the business cycle, and this argues for a degree of vigilance while recognizing that there are still opportunities in financial markets.