September 2019 - Market Research & Commentary
Following the FED’s decision to decrease the Fed Funds rate by 0.25%, speculation, headlines and general concern surfaced about potential for negative interest rates in the U.S. As we mentioned in last month’s newsletter, 10-Year German Bunds are yielding a negative nominal yield. The 10-Year Treasury has seen a significant drop in its yield as investors flock to safety, under the assumption that a cut in the benchmark rate by the FED means the economy is headed for a slowdown. The saying hasn’t been mentioned much recently, but we really do appear to be in a “lower for longer” environment. Fixed income is poised for another season of very low yields and by no means would this be the first time that the U.S. has seen negative real rates. Despite the persistence of abnormally low interest rates (by historical standards) the likelihood of negative nominal rates in the U.S. is remote.
A very brief history on negative rates. Negative nominal interest rates are a recent phenomenon, originated only seriously since the 2008/09 recession. To find another example of negative nominal interest rates, one has to look to Switzerland in the 1970’s. Negative interest rates were less of a direct policy decision per se but the consequence of significant currency appreciation that needed to be abated to avoid a recession (Swiss National Bank). Since then, negative interest rates first appeared again in Europe. Sweden first instituted a negative overnight repo rate of -0.25% in July 2009, fairly benign but still meaningful (Financial Times).
Interest Rates Today
Most simply, the issue with negative interest rates is it pays debtors to borrow, destroying the profitability of lenders and the economic incentives of providing credit. Exceptionally low interest rates, as we’ve seen in the last decade appears to have exposed the limits of monetary policy on affecting consumer and business behavior. Recent experience has shown its easier to get people to stop providing credit, i.e. by charging exorbitant interest rates, such as in the 1980’s, and the resulting halt in business activity, than it is to get them to do something, i.e. charging a little to no interest or even negative rates for borrowing, to ideally increase economic activity.
Chart I - 5-Year and 10-Year Real Treasury Yields
To appreciate the likelihood of negative nominal rates in the U.S., U.S. Treasury yields, since the European debt crisis, have been near negative and for many periods provided a negative real return, for 5-Year and 10-Year Treasury’s. Observing these negative real interest rates one can understand, or at least posit the argument that the U.S. could experience negative nominal interest rates in the near future. If investors’ expectations about returns are so bleak, and during the longest expansion period in the investors in Treasury’s were willing to accept very low returns, will they now be willing to pay to invest in the safest securities in the next downturn?
For some investors the answer is likely yes, they might be willing to make this seeming irrational choice. Thankfully in the U.S., the economy and its demographics don’t support a negative nominal yield much like they do in Japan and Germany. The regions that have negative yields, the Eurozone and Japan, have experienced substantial population growth slowdowns, or negative population growth. This negative population growth has led to a string of economic consequences, including lower GDP growth, lower consumption and lower inflation.
Chart II - Annual Population Growth: U.S., Germany, France, Japan, and Italy (data from World Bank)
As the chart above shows, major economies such as Germany, Italy, France and Japan have seen a fairly persistent downward trend in population growth. Japan’s is the most consistent with year-over-year negative growth since the mid-1970’s. The trend in the U.S. doesn’t exactly “pop-out” but its population growth has stayed around 1% in the last 40 years.
Chart III - Annual Change in inflation: U.S., Germany, France, Japan,and Italy (data from World Bank).
Since the post-WWII peak of inflation in the early 1980’s, annual inflation has decreased substantially and has rarely gone above 2% for the developed economies included. Following Japan’s real estate bust, and years of low population growth the country has been on a slow but methodical deflationary path. Despite Germany’s positive inflation, its national debt is negative acting as the de facto safe haven for the Eurozone by bearing the risk inherent in other Eurozone partners, such as Italy, who has also experienced periods of deflation.
This puts the U.S. in an interesting position, whose debt is considered “risk-free” and whose economy is still viewed as the most important in the world. Yet, investors continue to demand a positive nominal return on its national debt. Albeit the U.S. has been the only major economy to experience a recent rising interest rate environment, the likelihood that the U.S. experiences negative nominal rates is very low for the following reasons:
1. Population Growth
While the U.S. population growth is clearly slowing, the trend is relatively flat and the U.S. is still a major destination for immigration. For all the political gridlock, complaining about how bad things are, the U.S. offers tremendous freedom and opportunity for those seeking a better life. This population growth is in contrast to Japan, who has a homogeneous society, an aging population but has been very restrictive on immigration and foreign workers. The country just recently relaxed immigration laws at the end of 2018 (BBC). These less restrictive laws are going to take years to have an effect and reverse trends.
2. Independent Monetary policy
Somewhat obvious from the section header, independent monetary policy is vital in ensuring the interest rate and monetary environment is what is needed for a country. The Fed can operate in the manner it sees best for the economy, which is in contrast to that of Germany. The ECB has to act in the best interest of the entire Eurozone, which in some instances might be more helpful for Germany or less helpful. Arguably not so for the U.S., if a different monetary policy is called for, the U.S. can change gears and implement the policy needed.
3. The U.S. is an entrepreneurial society, this is inherently risky
Unlike other areas of the world, failed entrepreneurial activities are less prone to scrutiny in the U.S. The U.S. was founded on an entrepreneurial spirit. If a business venture fails, yes it will hurt, but the entrepreneur isn’t looked upon with contempt as he or she might be elsewhere. We would argue, not coincidentally, areas of Europe and Japan have more conservative attitudes towards business thus have lower growth prospects, and therefore lower yielding investment opportunities (e.g. negative nominal interest rates). As an example, The Global Enterprise Monitor’s 2017/2018 report found that only 5% of Japanese population was engaged in starting new businesses, while 13.6% of the U.S. population was engaged in starting new businesses (GEM).
4. Sovereign debt in the U.S. is comparatively low
The U.S. national debt has reached unprecedented levels for a peacetime economy, its Debt to GDP ratio is lower than that of the most indebted countries. Japan’s is well over 200%, Germany’s is still quite moderate, around 50%, the U.S. is now over 100%. But, again, the U.S. lacks two major characteristics that limit its ability to experience negative nominal yields. The first is Germany is seen as the safest subsection of a currency bloc. If one was able to set up Treasury issuance based on different economic zones in the U.S. then maybe a negative rate could occur for certain sovereign debt securities. But even that seems a stretch given that the most economically sound states and municipalities don’t have negative nominal rates.
Second, the market for U.S. Treasury’s is robust and is not completely propagated by the central bank. This is said in relation to Japan whose central bank, the Bank of Japan now owns 45% of the Japanese Bond market (Reuters).
Interest rates tend to follow long-term trends, today we still appear to be very much in a lower for longer trend. The issues of very low interest rates for the developed world have been thoroughly discussed and are likely to affect policy decisions for years to come. For the U.S. the extremes of negative interest rates are unlikely to come ashore. That doesn’t mean we might not see some additional yield compression in in long dated U.S. Treasury’s in the next recession as we’re already seeing.