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Uncommon Sense March 2016 Are Negative Interest Rates the Next Black Swan? by Michael Arone, CFA, Managing Director and Chief Investment Strategist for US Intermediary Business Group “We can be heroes, just for one day.” — David Bowie Seven years after the global financial crisis and Great Recession, the global economy remains mired in growth purgatory, despite the best efforts of central bankers. Economic growth is underwhelming everywhere — in the US, Europe, Japan and even China. And now that anemic growth could be slowing further. As a result, a dangerous game of chicken is breaking out among central bankers. They are vying with each other to concoct the new monetary policy that can finally reignite domestic growth and inflation. Acting as super heroes sent to save the global economy, central bankers have tried every existing policy measure. They started out with lowering interest rates and bond buying (quantitative easing), and when that didn’t work they reduced rates to zero. Now, negative interest rate policies (NIRP) have become a reality and there are whispers in the wind of even more extreme measures such as flinging “helicopter money” directly to consumers to encourage them to spend, or to governments for infrastructure investment. As J.P. Morgan’s Alex Dryden so eloquently puts it: “We are moving from a low yield environment to a no yield environment.”1 However, supposedly omnipotent central bankers may want to consider that NIRP could actually become the next Black Swan due to unexpected consequences of the latest experiment in monetary policy. In this new era of aggressive central bank actions, a quarter of the world’s sovereign debt has negative yields,2 and Federal Reserve Chair Janet Yellen has said the Fed has at least considered the idea of negative rates in the US. The theory behind unprecedented monetary accommodation and negative rates is they boost financial asset prices and lower the cost of capital, eventually leading corporations to pursue greater capital expenditures and consumers, feeling wealthier, to spend more. Well, that’s the theory, anyway. Figure 1: Selection of Countries with Negative Bond Yields Switzerland 70 Germany 58 Japan 57 Finland 50 Netherlands 47 Austria 46 Sweden 45 France 42 Belgium 28 26 Denmark 0 20 40 60 n Percentage of bonds with negative yields Source: Bloomberg Finance LP, Deutsche Bank Global Markets Research, February 2016. 80 Uncommon Sense | Are Negative Interest Rates the Next Black Swan? Yet as Bridgewater Associates’ founder Ray Dalio recently pointed out in a note to clients, QE can push asset prices somewhat higher, but investors and savers will still want to save, and lenders and borrowers will remain cautious so central banks are “pushing on a string.”3 I agree, and feel that demographics and aging populations around the world are a big and overlooked reason why easy monetary policies haven’t been enough to trigger the growth we desperately need. It’s possible that no amount of QE will cause aging populations to consume rather than save, and that these policies may actually be hurting the economy. In fact, since the Fed lowered rates to zero in 2009, the savings rate has actually trended higher (see Figure 2). Figure 3: Inflation: Monthly Change in Consumer Price Index (CPI) 16 12 8 4 0 -4 1970 1977 1985 1992 2000 2007 2016 Source: Federal Reserve Bank of St. Louis. Data shown is January 1, 1970 to January 1, 2016. Consumer Price Index for All Urban Consumers: All Items. Monthly percent change from a year earlier. No Pain, No Growth There are simply no more easy policy choices left. The can has been kicked as far down the road as possible … yet it keeps rolling back. We may have to face the fact that easy monetary policies alone, without structural reform, won’t be enough to spark global growth. 15% in March 1980.4 Volcker increased short-term interest rates to previously unimaginable levels to vanquish inflation. He knew there would be tough consequences for the economy, capital markets and financial system. The US economy suffered for a while longer until inflation was tamed and interest rates could be lowered. Only then did a real economic recovery gain traction. This certainly isn’t the first time that we’ve faced tough challenges. For those old enough to remember, the stagflation of the 1970s and early 1980s was one of the worst investing environments in recent history. Rising inflation coincided with higher unemployment and a slowing economy to create a truly toxic mix. Similar to investors’ recent experience, the stock market had some good years and some bad years, but mostly went nowhere. Today’s primary economic challenge is certainly not spiraling inflation, but rather lackluster growth and fears of deflation. The policy choices will most definitely not be the same, but that doesn’t mean they will or should be any less painful. Yet central bankers keep doing the same thing over and over again and expecting a different result. They have created the Participation Award economy where everybody gets a trophy, Enter Paul Volcker, the cigar-chomping Federal Reserve chairman under Presidents Carter and Reagan who is credited with breaking the back of inflation, which topped out at nearly Figure 4: US Population 65 Years and Over: Past and Projected Figure 2: Savings vs. Rates US Gross National Savings Rate as % of GDP US Fed Funds Effective Rate (%) 24 20 22 Population (M) % of Population 600 30 16 500 25 20 12 400 20 18 8 300 15 200 10 16 4 100 5 14 1980 1987 1994 2001 — US Gross National Savings Rate as % of GDP — US Fed Funds Effective Rate Source: Bloomberg, as of December 31, 2015. State Street Global Advisors 2008 2015 0 0 1900 n US Population 1950 n 65 years and over 2000 2035 2050 0 — % of Total Population Source: US Census Bureau, Population Division, December 2012; Demographic Trends in the 20th Century, November 2002. 2 Uncommon Sense | Are Negative Interest Rates the Next Black Swan? and nobody is allowed to fail. I think we need a “hero” like Volcker to step up and make some difficult decisions that could result in short-term pain, but for long-term gain. The truth is that in a healthy, dynamic and balanced economy, not everyone wins. Some must lose. Sometimes the system just needs to be cleared to build the proper foundation for the next cycle of growth and innovation. That’s how capitalism works. US Social Security Administration Total Beneficiaries (M) 65 68 59 66 53 64 47 62 41 2001 2008 Jan 2016 <35 35–39 40–44 45–49 50–54 55–59 60–64 65–69 70–74 75–79 80+ Source: Federal Reserve Survey of Consumer Finances, 2013. 70 1994 3 n Financial Assets ($ Trillions) Figure 5: Workers vs. Savers 1987 4 0 Therefore, I believe it’s time to stop focusing on boosting consumption through aggressive and unprecedented monetary policies, and start focusing on increasing production and income for an aging population. Monetary policies have focused only on one group of beneficiaries of lower rates — borrowers. Central bankers have ignored the negative impacts that financial repression has on the amount of income savers get on their money. Compared to the 1930s and 1970s, the US and other advanced economies are getting much older. As a result, there are a much greater proportion of older savers today than at any other time in history. Not only that, they own a vast majority of the assets and wealth. Mar 1980 5 1 Today’s problems are different from those we faced during the Depression Era 1930s or the stagflation 1970s. Additionally, demographic shifts underscore that solutions that worked during those time periods probably won’t work now. In the US, we are a much older nation these days, and the trend is also evident in many other developed economies. Importantly, the portion of US households aged over 65 has increased by 3.5% since the last business cycle peak, and is set to increase by an additional 6% over the next decade (see Figure 4). 60 6 2 Demographic Challenges and Different Solutions Labor Force Participation Rate (%) Figure 6: US Household Assets by Age 35 These older savers are being penalized by lower rates and we’re forcing them into riskier assets. And they hate it! This growing group of wealthy savers has less money to spend because interest rates are being repressed. I believe this is hurting economic growth more than anyone realizes. Heroes Wanted Until recently, low rates were viewed as a panacea for all that ails the global economic system. As a central banker, when all you have is a hammer, everything starts to look like a nail. That’s why we have NIRP, which was put in place by the European Central Bank (ECB) in 2014 and subsequently adopted by Denmark, Sweden, Switzerland and Japan in late January 2016. Negative rates could even be heading to the US at some point. This makes an already tense situation for global financial institutions worse to the extent that negative rates compress net interest margins and wreak havoc on savers. Can an asset be considered risk-free when one must pay the issuer to own it? In short, there are no risk free-assets in countries with negative interest rates. Paradoxically, investors may need to take greater risks with capital that should be risk-free, or save more to meet future spending needs. Neither consequence supports prudent capital allocation or economic growth. Until central banks restore their credibility, it seems likely that market volatility will continue. Tough choices will be required, and there will be some winners and many losers. The next phase of the journey will not be for the faint of heart, so only heroes and leaders need apply. — US Labor Force Participation Rate — US Social Security Administration Total Beneficiaries Source: Bloomberg, as of December 31, 2015. State Street Global Advisors 3 Uncommon Sense | Are Negative Interest Rates the Next Black Swan? Notes & Sources: “Negative Interest Rates, A Modern Policy Error, and the New Bid for Gold,” Strategas Research Partners, February 12, 2016. “Increasingly Addled,” Bill Gross, Janus Capital Group, February 3, 2016. “Hoisington Quarterly Review and Outlook - 4Q2015,” Van R. Hoisington and Lacy H. Hunt, Ph.D., January 20, 2016. “The Fed Prepares to Dive,” John Mauldin, February 22, 2016. “Helicopter drops might not be far away,” FT.com, February 23, 2016. “The Silver Age of the Central Banker,” Epsilon Theory, February 19, 2016. “(Monetary) Napalm in the Morning,” Convergex Market Commentary, February 24, 2016. “The US Consumer: Research and Results, Demographic Notes: A Boomer Bust?,” Empirical Research Partners, January 26, 2016. “Investors seek long-term debt as yields drop,” FT.com, February 25, 2016. “Record $5.5tn in govt bonds with negative yields,” FT.com, January 29, 2016. 3 “’Helicopter money’ on the horizon, says Ray Dalio,” FT.com, February 18, 2016. 4 Based on year-over-year changes in the Consumer Price Index. Source: US Department of Labor, Bureau of Labor Statistics. 1 2 ssga.com | spdrs.com For public use. State Street Global Advisors One Lincoln Street, Boston, MA 02111-2900. T: +1 866 787 2257. 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