Philadelphia Reflections

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Negative Interest Rates and the Next Crisis

The United States government is pumping money into foreign countries.

Really? Yes, really. On the Fourth of July 2019, all of Europe plus Japan have negative interest rates on their sovereign debt.

Negative rates: the lender pays the borrower, a situation unknown in all of human history.

OK. So what fool would buy a bond with a negative yield? I'm not sure about this except that there are a lot of gamblers investors who buy a negative yield hoping for a lower one; an odd profit perhaps but a profit nonetheless. Maybe. For a while.

The buy side of negative-yielding bonds may be a little murky but the sell-side is clear enough: borrow money from people who will pay you for it and buy US Treasury bonds.

Take Germany for example: borrow 3-year money and receive 0.760%; turn around and buy US Treasuries and receive an additional 1.805% ... receive in total 2.565% care of a swarm of gamblers and Uncle Sam. Locked-in for three years (or even better if rates continue to fall and you sell early).

So, everybody sort-of knows that yield curves are inverting and that the last time this happened it preceded a crisis by about 18 months. But do you actually know what these curves look like? Here are the US Treasury yield curves last time (2006) and now (2019). Notice first that rates today are a lot lower, second that the dip in the middle now is a lot deeper this time, and third that the 30-Year is not inverted this time, at least not yet.

The spread difference is really quite striking:

Why is today's negative spread in the middle so deep? A lot of the explanation is that foreigners are buying our debt. And not just foreign treasuries, everyone can see this yield spread, but foreign treasuries get the extra kick of their negative yields. This is perverse on its face but insidious also is the motivation to issue more and more debt for the sole purpose of arbitrage ... foreign governments are in the hedge-fund game.

... foreign governments are in the hedge-fund game at the expense of the United States Treasury.

Foreign rates have been driven negative with the idea that it will stimulate growth. Which it does not appear to be doing. Nothing in this scenario is in any of the economics textbooks.

Notice first that rates today are a lot lower

Based on historical precedent, an economy as hot as the US's today, after a ten-year recovery and bull market, should have much higher rates. Who cares about historical precedent? Well, the way the Fed "saved" us the last time we had a crisis was to lower rates. If we need saving again anytime soon, lowering rates may very well take the US into negative-rate territory as well. Some are predicting that the arbitrage will take us there even sooner.

Aren't low rates good? Trump says so; he wants to fire the Fed Chair to get them. So negative rates must be better still. Well, if you're a borrower, sure. But there are at least three reasons to worry.

1. The Baby Boomers are retiring in their millions and their demographic will overwhelm us as they have been doing since the 1960's. And what do retirees live on? Fixed Incomes, that's what, and the Boomers are getting screwed. Forget about the pension crisis, just low, zero or negative rates will be enough to impoverish the largest voting segment in history.

2. Interest rates are the price of money. When money is free, it will be squandered. Right now, there are thousands of companies that deserve to be bankrupt that are being kept alive with free money. Corporations are buying back their stock at the top of the market with free money. Governments are borrowing free money to cover a buying spree that is being financed instead of paid for with taxes; inflation so-far has been dormant in the face of a colossal increase in debt. All this adds up to a justifiable concern that the crisis next time is likely to dwarf the last one, and the last one was a doozie.

3. The Fed has become impotent. The Greenspan put used to be a reliable moral-hazard backstop. And now? Last December there was a taper tantrum (a stock market crash of nearly 20%) in response to a tiny rate increase from very-low to just-a-little-higher. Plus the Fed balance sheet is stuffed with bonds. Next time, what? Lower/negative rates and even more stuffing, to also include equities? What choices are there? The US government is spending its way into oblivion and it is nationalizing all the bonds to allow it to continue; and will it, next time, nationalize the stock market as well? This cannot lead to a good place.

I'm reminded of the people living in flood plains who have had their houses repeatedly rebuilt. Can this really continue?

Right now, the stock and bond markets are reaching new highs and mortgages are tantalizingly low. In the long run, we're all dead and I'm getting closer to that every day, but I figure I've still got another 30 years, so do I feel lucky? Do you, punk?

Notice second that the dip in the middle is a lot deeper this time

The long end hasn't inverted, but in the middle the arbitrage game is producing a much more extreme result this time. History only rhymes, but if the yield curve is a signal, it's blinking brightly about something. History would say that right around election time something bad is going to happen; it may also be saying that just before that the stock market will go up another 20%+, so get your limit orders ready to take some profit and then batten down the hatches.

Notice third that the 30-Year is not inverted this time, at least not yet

I guess if you're in the market for battens, this might be a good place to look. Zero-coupon, in particular. If bond-buying isn't to your taste, perhaps TLT could be substituted, but there's no guarantee of a return. At least a Treasury will give you back what you asked for when you bought it.

Of course, this thought is based on the history of 2000 and 2008. Druckenmiller is doing it again, and he's been very successful, but maybe the rhyme this time will surprise us. All I know for sure is that things are extremely upside down right now.

Originally published: Sunday, July 07, 2019; most-recently modified: Saturday, September 07, 2019

 

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