By Grayden Taylor – Investment Manager
I was recently going through some old photo albums and came across some photos of myself in the 80s, sporting a classic mullet hairstyle and wearing a pink, green and yellow fluoro shirt. It immediately made me think of negative interest rates. It may seem a bit of a stretch, but there are some phenomena we get caught up in at the time, only to find ourselves looking back years later and asking, “What were we thinking?”
This tends to be the nature of financial market bubbles, with probably the quintessential example being the ‘tech bubble’ of the late 90s, where the valuation of companies bore no semblance to their future profitability. Companies with no revenues and massive expenses were trading at ridiculous prices, with analysts and market participants inventing new metrics, in a vain effort to justify what was going on.
Hindsight is a wonderful thing
After the inevitable happened and reality (and sanity) returned, those same market participants looked back, and with the benefit of hindsight, acknowledged that the price movements didn’t make sense and should never have happened. In the end, the only way people were going to profit from investing in these companies, was to sell them at a higher price to someone else prepared to pay an even more ridiculous price – in other words, to find a bigger fool.
As bubbles form and continue to gain momentum, this can be a very successful and profitable strategy, but it can be brutal on those left holding the can, when there’s no one left to pay a higher price.
While not as crazy as the tech valuations, the concept of negative interest rate policy is something we will need to look back on to understand the true impacts and consequences it has had. Negative interest rates are not completely new. In Switzerland during the 70s, negative rates were used to stop the rapid appreciation of the Swiss franc, as investors sought to avoid inflation in other parts of the world. What is new however, is the widespread occurrence of negative interest rates across Europe and in Japan, with a third of global government debt (about $7 trillion worth)1 now having negative interest rates. This means that investors are effectively paying to keep their money with the bank or to lend money to a borrower.
As a real world example, imagine if you could get a car lease at a negative finance rate. You could turn up to the dealership, drive away a brand new car, return it years later at the end of the lease and receive a payment from the car yard! I’ll take a Bentley Continental GT please, one of the convertibles! Why would they do this? Quite simply, they wouldn’t! But investors, it seems, are expecting economic stagnation, and ultimately deflation for an extended period of time.
Global growth forecast better than expected
However, while not exactly racing along, the data for global growth doesn’t really support quite such a bleak outlook. In January, the World Bank downgraded its 2016 growth forecast to 2.4%, from the previous 2.9%. Despite problems in Europe and emerging markets such as Brazil and Russia, China is still projected to grow at 6.7%2 and the US at 2%3.
So if we’re not likely to get a deflationary environment, the only thing left for buyers of bonds with negative rates to have a positive return, is for them to find a buyer for those bonds at an even more negative interest rate – a bigger fool. A period of stronger than expected global growth and an uptick in inflation, should it occur, will mean that the buyer is unlikely to appear, and we’ll see an end to the bond bubble that has grown over the past decade. Should this occur, the massive capital appreciation we’ve seen in the bond market will reverse, and we’ll get a normalisation of interest rates along the yield curve. So make sure you’ve locked in the interest rate on your Bentley – those things are expensive!
Grayden is a member of the Investment Team at Elston and is responsible for portfolio management. His experience spans domestically and internationally in several sectors of the financial markets including equities, equity derivatives, trading and market making. Grayden worked as a market maker in bond and equity derivatives on the Sydney Futures Exchange before managing portfolio trading operations in Hong Kong and Brazil prior to working at Elston.
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