The View

How to survive in the brave new world of negative interest rates

The new portfolio for perilous times is high quality bonds, gold and some cash

PUBLISHED : Thursday, 21 July, 2016, 2:46pm
UPDATED : Thursday, 21 July, 2016, 2:50pm

It remains an article of investment faith that low interest rates translate into stimulus and growth, but history and current events are proving this to be dangerously wrong. Negative interest rate bonds and bank deposits have become an expanding asset class.

The trade started in smaller countries then spread to Germany and Japan. Today there are close to US$17 trillion of negative yield sovereign bonds. And their issue by central banks is setting up another financial and political crisis that regulators and central banks will be unable to stop.

Central banks have rewarded the return-seeking bond buyer and they’ve done nothing but penalise the income-seeking bond buyer and depositor

This colossal debt issuance compounded the credit folly of the 2008 crisis to spawn problems you can see from America to Hong Kong. Little of the increased corporate or government borrowing due to low rates trickled down into creating jobs or real income growth.

Real wage growth has been non-existent for more than a decade in the US and Hong Kong. To fund the artificially low interest rates, central bank balance sheet expansion required the imposition of negative rates. This means charging you interest penalties if you don’t buy longer term bonds.

Now your average portfolio investor and retiree living off savings have been cruelly deceived with this distortion in saving principles. Venturing into negative yield has potential if you’re an investor looking for a percentage return on your bond portfolio. It is terrible if you’re an investor looking for an income from your bond portfolio.

Over the past seven years, central banks have rewarded the return-seeking bond buyer and they’ve done nothing but penalise the income-seeking bond buyer and depositor. It’s almost immoral to charge people for keeping savings in a bank, but that is where we seem to be headed.

We are afflicted by zero wage income growth because corporations are borrowing money for stock buybacks instead of investing for growth. Investment income growth is below zero because central banks have suppressed rates. Thus, you have the perfect formula for a widening of the wealth gap and class division.

The behavioural investment outcome of negative interest rates results in two very different and opposed fixed income investors: return seekers versus income seekers. Both have completely different motivations for buying bonds in this kind of environment. The return seeking bond investor is hoping that yield goes from - 0.1 per cent to -1 per cent. The income seeker believes it is irrational to buy a negative yield bond.

Most importantly, return seekers will only own a bond if they think that the price is going up. This means that yields must become even more negative as greater fools must being willing to pay higher and higher prices for them. Most importantly these investors will quickly sell their positions once they sense this game is over.

This simple behavioural model explains the US$17 trillion crowded momentum trade that is taking place on negative rate sovereign debt today. These investors will storm the exits and trample global markets when the ECB or BOJ reverses its policy.

Hedge funds and active asset managers have severely underperformed over the last year and previous eight years. According to Bank of America Merrill Lynch, just 18 per cent of large company funds outperformed the Russell 1000 in the first half of the year. It has been the worst year for active funds in their history since 2003.

Few bankers and asset managers in Hong Kong can explain what horrors negative rates might inflict on the economy and banks. The behaviour of Hong Kong depositors in the event local interest rates turn negative is difficult to predict. No one thinks it will happen unless the US introduces it, but hope is not an investment method.

It is not hard to imagine that Hong Kong depositors would be so mortified by negative rates that they would desert Hong Kong dollars in droves and precipitate a bank run. It could drive mass movement into gold or silver.

Over the last six months, the long term, diversified and balanced portfolio - another cornerstone of truth - has been rejected as a portfolio suicide mission. Private bankers and wealth managers have been unable to make sense of the S&P 500’s recent new highs relative to other asset classes.

Instead, the new portfolio for perilous times is high quality bonds, gold and some cash. Seek liquidity and safety. Go to your base currency and find dividend bearing stocks. Expect future investment conditions to deteriorate, not improve.

Peter Guy is a financial writer and former international banker