We’re going to talk about bonds today but before we get to that, I want to briefly point out why the Brexit event is impacting US markets so heavily.
As we’ve discussed many times here at DTL, the strength of the US dollar dictates the cost of US goods to our trading partners. When the dollar goes down, our goods go on sale; when the dollar goes up, it’s equivalent to a price hike across the board. And it goes without saying that higher prices stifle demand, which means less revenue, profits, etc.
With Europe thrown back into turmoil, investors are flocking to the US dollar for safety. This is how the dollar reacted on Friday and Monday.
This latest “exogenous shock,” as Bank of America Merrill Lynch called it, has switched investor psyche to risk-off mode, and that means sell equities, buy bonds.
Government bonds from the US to the UK to Germany, Italy and Japan are all moving higher. The move has been so strong it’s pushed the German 10-year yield into negative territory right alongside the Japanese 10-year bond.
Both of these countries (and others) can now borrow money for longer than 10 years without paying a dime of interest. In fact, lenders now pay them for the privilege of holding their money.
If you’re wondering how this can happen, and why anyone would buy bonds with a negative yield, you’re not alone.
Let’s start with the mechanics first, then we’ll dive into the crazy world of investor psychology that’s driving this madness.
Basic Bond Mechanics
Understanding bonds can be very complicated, or it can be very straightforward. We’re going to keep things simple for our purposes.
A bond is really just a loan. As with all loans, there is an agreed upon sum that is borrowed, and an agreed-upon repayment schedule.
These two facets of a bond never change except under rare circumstances. Whoever owns a particular bond is eligible to receive the initially agreed upon payments through the term of the loan, and then receive the sum of the loan upon maturity (known as the par value).
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So the compensation a bond owner gets back from a bond never changes; that’s set when the bond was originally issued. BUT … and here’s where things get interesting, bonds are always being traded on secondary markets. While the terms of a bond don’t change (the amount of the interest payments and principal returned at the end), the price that bond holders are willing to pay for the bond is constantly in flux.
If a buyer comes along and is willing to pay a higher price for a particular bond, then that new owner will receive a lower return (a lower yield) than the previous owner. This is because the compensation that the new bond owner receives doesn’t change, but because he paid a higher price, his effective return is lower.
So whenever bonds are in high demand, and prices are rising, it’s a sure thing that yields are falling. The relationship between bond prices and bond yields can be seen in the diagram below.
Now, what happens when demand for bonds is so strong that new buyers are willing to pay MORE for the bond than what that same bond will return in interest payments and principal?
Well, that’s where we enter the realm of negative interest rates …
Why Lend Money at Negative Rates?
You’ve heard me say this a thousand times, but I’m going to say it again. Investing is a game of relative value, not absolute. No financial asset on earth has any absolute value (it’s all paper and claims, remember?).
Even gold (grit your teeth) has no intrinsic value … its value is purely a function of what others are willing to pay for it, and that depends on what else is available and desirable.
When it comes to investing there are few certainties. But there is one thing you can bank on. Everyone who has wealth is trying to protect and grow that wealth.
During some phases of the economic and market cycles, those investors are primarily concerned with growth. Other times, the prospect of growth looks so dismal that preservation of capital becomes the name of the game.
Because even if you can’t make money, you sure as hell don’t want to lose it.
For regular investors like us, not losing money is pretty simple. We can sell our positions in the financial markets and hold that cash in a money market or bank account. With FDIC insured deposits, there’s some semblance of security that our money is safe.
But what if you were responsible for protecting a billion dollars? Or a trillion? What would you do with that money? Your local Chase branch isn’t going to be too happy when you try to deposit that into your savings account.
So how do you protect large sums of money? You give it to the most stable governments in the world to look after it for you.
Time for a detour: Investing is a game of probabilities, and to play the game right you need to understand expected value theory. I’ve discussed this before, but it’s pertinent to our current topic.
Let’s say you have and you’re offered either in exchange for it (a sure bet) or you can choose to gamble (I mean invest) it with a 50% chance of receiving and a 50% chance of receiving . Which would you choose?
Assuming this is a repeatable game, your calculation should go something like this:
(50% x ) + (50% x ) = an expected value of .50
What this means is that played over and over again, the value of this “investment” will yield .50. Since is more than .50, you choose to take the guaranteed loss of and you live to play another day.
Globally, investors are making this same exact calculation except on a MUCH bigger scale.
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Essentially, they are recognizing that the expected payoff of investing in other markets (be they currency, equity, derivatives, whatever) is less than the guaranteed payoff of investing in negative yielding (but safe) bonds.
When faced with an environment where the perceived returns are either “lose a little” or “lose a lot,” they’re choosing the former. And that’s how babies, I mean negative interest rates, are born.
The other big elephant in the room when it comes to yields, and especially negative yields, is inflation, or rather lack thereof.
Most people think the Fed controls interest rates. They do, but only short-term interest rates. Longer-term rates, not just here in the US but everywhere around the globe, are controlled by the global investor community.
You can think of inflation as a flowing river. In order to stay in one place (retain purchasing power) we must constantly be paddling upstream – earning at least the rate of inflation. This is why you will see the long end of the yield curve react very heavily to inflation expectations.
If inflation is at 2%, then an investor must earn at least 2% on their money to break even. Thus they will typically “demand” this rate plus some type of risk premium in order to lend money.
But what happens when inflation slows to zero, or even worse turns into deflation? Then, returning to our analogy, the river either stops flowing or begins to flow backward.
Instead of having to paddle upstream to maintain purchasing power, we can now just sit in our inner tubes and float upstream.
The point is that earning zero percent on your money can still provide an increase in purchasing power in a deflationary environment.
In fact, if deflation is strong enough, you can even lose money and still increase your purchasing power as long as you are not losing money at a rate faster than deflation.
What I’m getting at here is the idea of real interest rates. You can have negative nominal rates but positive real rates at the same time. It all depends on how the prices of goods and services are trending.
While the US is not in a deflationary environment, many countries around the world are struggling with deflationary forces. In a deflationary world, you don’t have to make money to make money. You just have to lose money at a slower rate than deflation.
So negative interest rates, while very foreign to us, are not so far outside the bounds of conventional investment wisdom. They’re simply the logical solution for investors who want to protect large sums of capital in a world where growth prospects are weak and inflation is absent.
The preceding content was an excerpt from Dow Theory Letters. To receive their daily updates and research, click here to subscribe.
