The Positive of Negative Rates

May We Live In Interesting Times

Chinese Proverb

We live in a crazy world and in case you needed any more evidence to prove this, I offer you the idea of “negative interest rates”.

What are negative interest rates? 

To answer that let’s start with what an interest rate is in the first place.  An interest rate is the amount that is charged or paid for the use of money.  In the world of Government Debt this is expressed as the rate for government bonds.  In the U.S. we call them Treasuries, in Britain – Gilts, in Japan – JGB’s, in Germany – Bunds.  Just as each country has its own name for the bonds each has its own rate. 

The rate is supposed to provide some idea of how markets perceive risk.  A higher interest rate should indicate more concern or risk in getting paid back.  After all, the idea in lending is to get paid for the risk - if one borrower is higher risk than another than that borrower should have to pay a higher rate.  Makes sense, right? 

Remember the opening line about this crazy world?  Let me reintroduce something we shared in our last missive, "The Great Rate Experiment", to help bridge the current worlds craziness with the explanation of negative rates. Below is a list of 10 year interest rates of what is considered the more developed countries in the world as of March 10, 2016 according to Bloomberg.

  • U.S. 1.88%
  • U.K. 1.48
  • Canada 1.27%
  • France .64%
  • Germany .22%
  • Japan -.22%
  • Switzerland -.44%

See anything odd there?

The first odd thing that may come to your attention is that the last 2 countries – Japan and Switzerland - are negative.  The second odd item should be that out of the entire list the U.S. is the highest payer/yielder. 

Let’s first address oddity number 1.  How interested are you in loaning your money to the Japanese or Swiss government for ten years to receive less money back than you gave them?  Silly question?  If someone told you two years ago that someday you will live in a world that you not only get 0 return on your savings but that it costs you money to keep that savings with your government, would you have believed them? Probably not, but it appears we have entered that strange world and whether this new world will be good or bad for investors will be dependent upon the tools and knowledge they have at their disposal.  The reality is negative rates will create some unique opportunities while at the same time fueling new risks investors may not have thought about before.

To address oddity number 2, I have to take you back a few paragraphs to remind you of the original concept behind interest rates - to help gauge risk.  Presumably this would mean that if one country seemed higher risk than another then that country should be offering a higher rate for its bonds.  If this is the case, why is The U.S. at the top of the list?  I know there are multiple factors that are influencing these rates, most of which is the current Quantitative Easing program European and Japanese central banks are in the midst of.  I get that these governments are actively manipulating markets by buying every piece of Government Debt they can get their hands on to push rates as low as they can.  What I don’t get is how The U.S. rate can stay at these or higher levels in this type of environment. 

When I am perplexed by such fundamental questions, I like to go to the charts to see what they tell me.  First up is this chart of IEF, an exchange traded fund that attempts to track the price of 10 year Treasury bonds.  It is important to remember that bond prices are inverse of rates.  Which means that as interest rates decline the price of this asset should rise. 

When I see a chart like this, I see an asset that is in a rising channel depicted by the 2 solid green lines.  This is important because, regardless of my opinion about where rates may head in the future, the facts are that 10 year Treasury prices have been trending higher (rates lower) for quite some time and until this behavior stops it’s usually best to go with the trend.  You’ll know when this trend is at threat of ending when/if the lower green line gets breached.  Until then, the assumption is that this asset will have a tendency to want to travel back to the middle (dotted green line) or top green line as time progresses.  Subsequently, this would assume that 10 year rates continue to trend lower in line with the fundamental idea that U.S. rates need to come lower to be in line with the rest of the world. 

Since that last chart was a longer term view of prices let’s now give you a shorter term view of rates themselves.  Before I do, let me set the stage with an observation I have had after doing this for over 20 years.  That is, interest rates seem to like to trade in ranges for extended periods of time.  It seems that rates like to do a dance between two points for a period of time and then when the data changes on the economy the range gets readjusted. 

Case in point - throughout 2015 the Ten Year Treasury ranged between 2% and 2.5%.  When good economic data was on the table we pushed up to 2.5%, when economic data was weak we slipped down to 2%.  Now, I wonder if starting in 2016 we have started a new range that is possibly between 1.5% when things get a little concerning and 2% when things look to be OK in the world.  Enough with the talk let’s take a look at the chart below.

What is interesting to me is that if we are in a new range for rates, this range would coincide with the lower green and middle dotted line on the previous chart of IEF. 

So what is the point of all this?  After all the title of the article is, “The Positive of Negative Rates”.

Here is the bottom line.  This is a much different environment than it was when you most likely put together your retirement plan or investment allocation.  I don’t think there was an investor or an advisor in the world that thought they had to factor in negative rates to their plan when they were putting it together a few years back.  In fact, most have been planning and looking the other way as they have been focused more on rising rates than negative rates. 

This new environment most likely has less consequence for the young and working as it will continue to be a good time to be a borrower – hence one of the positives of negative rates, the ability to borrow cheap.  The problems for the young and restless will be different and probably bigger in the future.  However, if you are retired or close to retirement this new environment will have a drastic effect on how you manage risk and income creation moving forward. 

This speaks to using a new approach in allocating accounts.  An approach that is much more holistic and incorporates the ability to hedge as well as focus on creating a diversification that is truly diversified.  Not ten holdings with different names that all act the same when the markets rise or fall. 

As in any circumstance, as rates change there will be certain assets that will perform well, others assets that will not and possibly some that see extinction.  Knowing the difference will be key to managing the new environment. 

To this market observer, another positive is the intermediate term appears to be supportive for the run of the mill interest rate sensitive sectors.  However, this can always change and therefore we have decided to center our April events on this subject.  We hope you can join us Wednesday, May 11th where we will be discussing more on "The Positive of Negative Rates".

 

Colby McFadden

Quiver Financial

 

The opinions expressed are those of Colby McFadden and Quiver Financial as of March 29, 2016 and are subject to change due to market or other conditions. This is not a solicitation or recommendation of any investment; always consult a Financial Advisor before investing into any investment. Securities offered through Newport Coast Securities, Inc. - Member FINRA / SIPC - Advisory Services Offered through Newport Coast Securities, Inc. 18872 MacArthur, 1st Floor, Irvine, CA 92612 - 800.992.5592