This Time it IS Different
The four most dangerous words in the world of finance, often repeated, are “This time it’s different.” During both of the last two major booms and busts, a common belief was that the new internet age was different (2000) and later, that housing was also different (2008).
However, used to describe our current interest rate environment (particularly negative interest rates), the over-worked phrase actually does ring true.
Financial journalist and observer Jim Grant noted at a recent investment conference that research on interest rates shows that over the past 5,000 years of history, there has never been an instance of negative interest rates… until now.
The ever quick-witted Grant remarked, “If these are the first sub-zero interest rates in 5,000 years, is this not the worst economy since 3,000 B.C.?” Perhaps. Or maybe this is just the first time in history where we have central banks active in monetary policy, attempting to drive interest rates as low as possible.
Record Negative-Yield Debt
The current amount of debt sporting a negative yield continues to grow. In early 2016, there was over $5 trillion in negative yielding debt. This grew to nearly $12 trillion by the end of June, and it is now closer to $13.4 trillion!
Not only has more debt become negative in yield, but it is increasingly happening to longer term debt. Yields on 10-year government bonds have become negative for Germany, Switzerland and Japan.
Remember that bond yields are an inverse to bond prices. As bond prices get bid up, their yields go down.
What makes this unique is that bonds are a relatively simple financial instrument. Bonds do not have the subjective valuation that applies to stocks, and this makes the math and the logic of bonds fairly straightforward.
A person can buy a stock from another person while thinking it still has the potential to go higher, given higher growth prospects for the company. The price is based on one person’s subjective valuation.
On the other hand, bonds are not as subjective. If you buy a bond at a certain price, with a certain coupon payment, then the yield is a mathematical certainty. It is the yield you will receive per year if you hold the bond to maturity, and if it pays the principal in full without defaulting.
What Bond Buyers are Saying
By stark contrast, today’s current bond buyers are purchasing a security where they know they will lose money if it is held to maturity. For example, if you buy a bond today with a negative 0.5% yield, and it has five years until maturity, then after five years, you will be paid back less than what you originally paid for the bond. Even with the coupon payments you received during the life of the bond, the total payout will be equivalent to getting a minus 0.5% return on your money.
Therefore, we must make one of two different assumptions about current buyers of negative yielding debt. One assumption is they could be anticipating the bonds will continue to go up in price and that they will then sell them for a profit. In other words, the negative yields will become even more negative, and they will sell the bonds before maturity.
Unfortunately, this requires the buyer to believe there will always be a ‘greater fool’ out there who is willing to accept a higher price than what the original buyer paid. It it not unlike those who bought houses before 2007 on the premise they would flip them to a higher bidder. Remember that with bonds, someone must be holding these financial instruments at all times.
The second assumption is that buyers are perfectly fine accepting a negative yield, and are willing to ‘pay for the privilege’ of lending out their money. This goes against all basic laws of finance. It only makes sense insofar as these buyers have no other place to put their money, and are therefore choosing the lesser evil.
But this is a weak explanation, because they could put their money in cash and get at least a zero percent return. Also, this doesn’t seem to make sense for longer maturity debt, as it means these buyers think negative interest rates are here to stay for at least ten years or more.
Both of these scenarios point out how this time, it is very different, and we are living in a twisted financial world, a world only exists because of the manipulations and distortions of central banks.
It is always precarious to try to make predictions, but it seems that there will come a time in the not too distant future when people will look back at this period and say “What were people thinking?”
Like a frog languishing in a slowly heating pot of water, investors have warmed up to the environment of negative interest rates, not realizing how absurd and dangerous the situation has become. But take time now to assess, and be well prepared for the inevitable.
In this zero/negative interest rate environment, it is stunning to consider that since 2000, the DJIA (Dow Jones Industrial Average) has increased in value 63% while silver has increased in value 289% and gold has increased 380%…. an annualized return of 23.75%!
Cash, anyone? Or gold!