(Aug 5): Interest rates around the world are heading lower as major central banks embarked on a fresh round of monetary easing. The US Federal Reserve cut its short-term policy rate, by 25 basis points as widely expected, for the first time since the end of the global financial crisis (GFC).
Earlier, the European Central Bank (ECB) signalled that it was ready to push deposit rates further into negative territory and restart quantitative easing (QE). Any normalisation of interest rates is now pushed beyond 1H2020, as inflation continues to fall well short of target. Plans for renewed stimulus come as manufacturing activities in the biggest eurozone economies, including Germany, France, Italy and the UK, slumped sharply with trade war conflicts weighing on exports. Manufacturing weakness is also seen in Asia and the US.
Central bankers remain convinced that cheap and cheaper debt is the answer to flagging growth. The resulting extraordinary monetary policy easing over the past decade has been key in driving up global indebtedness — though economic growth has been disappointingly sluggish.
Near-zero and negative interest rate policies have mostly benefited asset owners. The flood of liquidity has lifted prices for almost all asset classes — bonds, stocks, property and even gold — concurrently higher.
At the same time, they are devastating to individual savers as well as pension and insurance funds. Sustained low returns will result in a serious shortfall in financial targets over time through a compounding effect, which could lead to a full-blown retirement crisis in the future. Easy money is widening the inequality divide.
As interest rates continue to drop, investors are desperate for that little bit of extra yield. And that, I believe, is causing many to underprice risks.
This is compounded by investors leveraging up for the small positive returns over cost of funding since their borrowing cost is also falling, amplified by readily accessible liquidity.
Last week, I wrote about how equity investors appear to be underpricing the risks of highly geared companies. Current stock valuations are on the high side of historical ranges and do not appear to discriminate based on relative balance sheet strength. Companies with weak balance sheets and cash flows are especially vulnerable to any downturn in the economy and/or a reversal in the interest rate downtrend.
The bond market too seems to be mispricing risks, perhaps to an even greater degree.
Table 1 shows the current yields for select 10-year government bonds. In Europe and Japan, yields are negative, that is, they give less than zero returns if held to maturity.
As risk-free sovereign yields fall deeper into negative territory, they are dragging yields for the entire debt spectrum down with them. There are currently over US$13 trillion ($17.9 trillion) worth of negative-yielding bonds where, in effect, lenders are paying borrowers — not just governments but also corporations — to take their money.
Under normal circumstances, investors demand a premium for credit risks, that is, lower-rated bonds must give higher yields than higher-rated ones. Bonds with longer maturities will carry higher yields than those with shorter maturities, that is, a term premium, to compensate for receiving income in the future.
But we are not living in normal times. The yield difference between risk-free and risky investments has narrowed significantly as has the spread between short- and long-dated bonds, in some cases to negative.
Charts 1 and 2 show the steady decline in yield spread for long- and short-dated Malaysian Government Securities as well as the spread between the 10-year MGS and A/A2 corporate bonds.
We see this phenomenon of narrowing spreads around the world. In the extreme case, we have the inversion of the US Treasury yield curve — where the long-dated bonds are currently yielding less than short-term notes, that is, the term premium is negative.
That said, the price distortion appears less extreme in Asia compared with that in developed markets. This could be attributed to the effects of massive QE in Europe and the US as well as the perception of lower risks in developed countries.
Table 2 shows prevailing yields for a selection of Singapore bonds, of different ratings and tenures. The term premium remains positive, suggesting that investors are less convinced that interest rates would stay low for an extended period. The spread for credit risks, however, are similarly tight, especially in the shorter end.
An investor willing to accept negative annual returns for up to 20 years in perceived risk-free German bonds is shocking enough. But when risky junk bonds and emerging-market debt also start to give less-than-zero returns and investors oversubscribe on Austrian bonds to earn just a 1% nominal annual return for the next 100 years, one must question the efficacy of the risk pricing mechanism.
Even if inflation and interest rates stay low for longer, what are the odds they will remain so for an entire century? What if central banks actually succeed in fanning inflation?
Junk bonds are rated as such for a reason — these companies have a high probability of non-payment and/or going bust. Emerging countries have a track record for defaulting on their obligations.
Investors are being forced (by central banks’ actions) into riskier investments for yields. Are they also culpable of being overly complacent with respect to compensation for the risks undertaken?
Bonds are always perceived to be a safer option than stocks. But if and when any of the above scenarios come to pass, huge segments of the bond market could be wiped out.
Why do investors buy negative-yielding bonds, which are guaranteed to make losses if held to maturity? Aside from institutions that have no choice due to investment mandates, most investors buy on the expectation that yields will fall even further, for instance from -1% to -4%. Since bond prices are inversely related to yields, there are capital gains to be made.
Expectations for deeper negative yields, meanwhile, are underpinned by the belief that inflation will remain low in the long term. Many see similarities between persistent deflation in Japan (since the 1990s) and what is now happening in the rest of the world.
The Bank of Japan adopted a zero interest rate policy for two decades and in recent years, negative interest rates, as well as massive QE, but has failed to generate sustained inflation. Since the GFC, the Fed and ECB have embraced the same actions, and despite the massive liquidity boost, globally, inflation too has been consistently below target.
I think such a direct comparison is flawed. Japan’s persistent deflationary mindset is underscored by decades of falling real incomes and the propensity to save of an ageing population that is also shrinking in an insular society with limited immigration. While we do see ageing demographics in the US, Europe and parts of Asia, the world’s population — and, therefore, aggregate demand — is still growing.
The subdued inflation over the past 10 years is not because demand was lacking but, rather, because of the confluence of unique factors, including the emergence of China as the factory for the world, creation of global supply chains and trade as well as technological innovations. The benefits from some of these factors may be nearing the tail end. I will elaborate on this at some point in the future.
My Global Portfolio fell 1.3% for the week ended Aug 1, mirroring broad-based weakness in global markets. Last week’s loss pared total returns since inception to 9.9%. Nevertheless, my portfolio is still outperforming the MSCI World Net Return Index, which is up 7.3% over the same period.
Tong Kooi Ong is chairman of The Edge Media Group, which owns The Edge Singapore
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