SINGAPORE (Aug 26): US President Donald Trump urged the US Federal Reserve this past week to cut interest rates by at least 100 basis points and pursue quantitative easing. With the 2020 US presidential election on the horizon, Trump has a strong incentive to browbeat the Fed into keeping monetary policy as loose as possible and stave off any hint of an economic slowdown in the US. For equally self-serving reasons, I hope the Fed ignores Trump.
More than a year ago, I began holding much of the cash in my investment portfolios in the form of US dollars, because of the relatively high interest rates they offered. The risk I faced is that the Singapore dollar, as a matter of policy, is kept on an appreciating path versus a trade-weighted basket of currencies. But I figured that the relative strength of the US economy would keep the greenback firm against most major currencies, and that the Singapore dollar would probably display a weakening bias against it.
Things worked out quite well until late last year, when the Fed turned sharply dovish. The US dollar immediately weakened, and my US dollar deposits began getting rolled over at lower interest rates. Fortunately for me, there has since been a broad loosening of monetary policy around the world amid signs of slowing growth, fuelled in part by the US-China trade war. That has spurred a rebound in the US dollar, though interest rates on my holdings of US dollars have continued falling.
Since the global financial crisis, major central banks around the world have pursued ultra-loose monetary policies to avert the risk of deflation and support economic activity. In 2014, the European Central Bank began paying commercial banks negative interest rates on the deposits they held at the ECB. The Bank of Japan began doing the same thing in 2016. Combined with all the quantitative easing, this pushed yields in some segments of the global bond market into negative territory.
With the dovish turn by the Fed at the end of last year, negative bond yields are becoming even more common. By some estimates, the market value of bonds with negative yields to maturity has surged to almost US$17 trillion ($23.6 trillion), well surpassing the peak set in 2016, when the pace of Fed rate hikes gathered pace.
According to the Financial Times, bonds issued by Japan, France, Sweden and Belgium now have negative returns out to 15 years’ of maturity. Germany’s entire bond yield curve, all the way out to 30 years, is now trading below zero. Countries that account for almost a quarter of total global output now have central banks with policy rates set below zero, the FT reports.
Yet, for ordinary people who are saving and investing to fund their retirement years, the concept of negative interest rates feels unnatural. It seems to penalise diligent savers and promote reckless risk-taking that usually ends in tears. Indeed, if pushed too far, there seems little incentive for savers and investors to even participate in the financial system. Why own a bond that will not give you a positive return? Why keep cash in a bank instead of under your bed if interest rates are negative?
Road to negative rates
There is, however, some logic to the seeming madness of negative interest rates. In fact, it has been a subject of academic discussion for more than 100 years. One narrative is that money gets hoarded during times of extreme uncertainty, and imposing a cost on holding cash is necessary to get people spending and investing again.
Silvio Gesell, a merchant and social activist as well as a self-taught economist, suggested in 1891 that a stamp worth one-thousandth of a note’s face value be attached to it every week for the note to remain legal tender. The cost of the stamps amounted to a depreciation rate of about 5%. Gesell’s justification for wanting to tax money in this way had to do with his criticism of rentier-capitalism. Yet, his vision of a monetary system that deterred the hoarding of money, thus enabling governments to effectively steer the amount of money in circulation and achieve their monetary policy goals, drew the attention of no less than John Maynard Keynes and Irving Fisher during the Great Depression years of the 1930s.
Another explanation of the need for negative interest rates is that inflation expectations have been on a secular downtrend in developed countries, because of ageing populations and increasing automation. Certainly, inflation has not been as much of a problem as it was in the 1970s, and successive peaks in interest rates have declined over the last couple of decades. One could also argue that keeping asset prices aloft has become an important element of preventing economic activity from crumbling. Against this backdrop, central bankers have needed to abandon their predilection for tightening monetary policy in anticipation of inflation, and come up with more creative stimulus initiatives as interest rates approached zero — such as experimenting with quantitative easing and negative interest rates.
Perhaps the more important question is whether such monetary stimulus measures will only be needed temporarily, or if ever larger doses of the medication will be necessary to revive the global economy. Three years ago, it seemed that the US was leading the developed world out of their post-crisis economic malaise. However, by the end of last year, it had become clear that further Fed hikes would weigh on growth in the US, and cause turmoil in global markets.
Is it only a matter of time before lacklustre growth and a recession or two push the Fed into setting its policy rate below zero? How much more creative will central bankers have to become to levitate asset markets? Where does this leave investors?
Active management required
On the face of it, with the Fed and other major central banks pushing interest rates lower, global capital is likely to flow into riskier asset classes. Investors hunting for yield, for instance, might choose to move from government bonds to corporate bonds in search of higher yields, or even to real estate investment trusts and high-dividend stocks.
However, investors should be prepared to actively manage their portfolios. For one thing, after the sharply dovish turn by the Fed, expectations are high that the Fed will keep cutting rates this year. Any hint of the Fed not fully meeting these expectations could cause a nasty selloff. And, any economic or inflation shock that makes continued monetary loosening appear untenable or unnecessary could cause a major dislocation in global markets.
In particular, Fed chairman Jerome Powell’s comments will be closely watched when he speaks on Aug 23 at the annual economic policy symposium at Jackson Hole, Wyoming. Minutes to the Federal Open Market Committee meeting that ended on July 31, which were released last week, showed a range of opinions on the first cut in the federal funds rate in more than 10 years.
“A couple of participants indicated that they would have preferred a 50bps cut in the federal funds rate at this meeting rather than a 25bps reduction,” one portion of the minutes read. “Several participants favoured maintaining the same target range at this meeting, judging that the real economy continued to be in a good place,” the minutes added.
The minutes also revealed that “a few participants expressed concerns that further monetary accommodation presented a risk to financial stability in certain sectors of the economy”, or that a reduction in the federal funds rate “could be misinterpreted as a negative signal about the state of the economy”.
Separately, it is unclear how long investors will tolerate negative interest rates. An attempt by Germany to sell €2 billion ($3.1 billion) of zero coupon bonds last week did not go well. Less than half that amount was sold, at a yield of minus 0.11%. Germany is reportedly considering more aggressive fiscal spending to boost economic activity.
My own inclination is to avoid chasing risk for the moment, and avoid exposure to companies that are big lenders or borrowers — such as banks and REITs, which have generally delivered strong returns over the past few years. I would also not completely abandon the safety of bonds or cash, despite the falling yields.
It is probably worth pointing out here that an actively managed bond portfolio is not doomed to lose to money even if the bonds it holds have negative yields to maturity. If the bond yield curve is upward sloping, gains can be generated through “roll-down”, that is, holding a bond for a period of time and then selling it at a higher price as its maturity shortens. Also, bond prices could just keep rising in response to ever-looser monetary policy. Even if bonds are beginning to look less interesting as yield instruments, they could still be a useful form of insurance against further economic weakness.
As for the US dollars in my investment portfolio, I am inclined to just hold on to them for now. The US economy might be softening, but it is still in better shape than most other major economies. And, as long as the Fed ignores Trump’s calls for an unnecessary 100bps cut, the US dollar might even strengthen a bit from current levels.
