In just a quick recap of the week, both stocks and bonds traded with a weaker tone despite the decline in Treasury yields and strong 1Q earnings. It appears that investor sentiment has been adversely affected by a combination of ongoing rate concerns, continued elevated volatility, and a stronger dollar. However corporate fundamentals and the global economy remain solid. Trade negotiations will be a key focus in the coming weeks.
I’ve wanted to write a note on the subject of interest rates for a while, but I’ve had a tough time figuring out exactly what I wanted to say. Stanley Druckenmiller’s op-ed (#1 in top 10 reads) provides a good base to build on. Let’s start with the fact that interest rates are the most important prices in capitalism. The intrinsic value of almost every asset (Bitcoin being an obvious exception) is the present value of its future cash flows. Every capital budgeting decision is made on the basis of—or should be made on the basis of—a project’s net present value. The key common factor in these calculations is the discount rate, which is just the risk-free interest rate (3 Month T-Bill yields for practical purposes) plus some type of risk premium for duration, credit, equity, and many other types of risks. What are interest rates exactly? An interest rate is simply the price of money. When anybody needs cash, the interest rate is the price they pay each year to borrow that money. When the demand for money is greater than the supply of it, interest rates go up, and vice versa. The key point is that they are prices, and like any prices, they are better discovered than administered.
The disconnect between price and value in the global bond market is immense. Never in 5,000 years have interest rates been below zero—today, more than $3.5 trillion of bonds worldwide trade with negative yields. It is evidence of the most radical, improvisational, and reckless monetary tinkering ever seen. Bond selection is a negative art. It’s a process of rejection. The most you can get back is par with interest. When you look at a bond, you’re supposed to be inherently defensive. However, the current environment is what you get when Mario Draghi is bidding against you.
While it’s hard to understand negative interest rates, it shouldn’t be too hard to understand the differing incentives of market participants. The central bank decision makers have a completely different set of incentives and goals than other market participants. On the surface, these policies are put in place to combat weak economies, spur economic growth, and reduce unemployment—oh and of course to hit a 2.0% inflation target. However, it can be argued that other reasons are playing a larger role. Right now US total public debt as a percentage of GDP sits at 104% and is increasing ever year. The federal government’s annual deficit is expected to exceed $1 trillion in 2020, and national debt of $21 trillion will soar to more than $33 trillion by 2028, according to the CBO. Countries such as Japan (253%) and Italy (132%) have higher debt-to-GDP ratios and are in even worse shape. This is unsustainable, and you might be able to guess why central banks would want to engage in financially repressive policies.
A subtle type of debt restructuring takes the form of “financial repression.” Financial repression refers to a set of government policies that create an environment of low or negative real interest rates, with the unstated intention of generating cheap funding for government spending. However, this has been taken to the extreme in the current regime of central bank policy to the point of debt liquidation. To steal from Carmen Reinhart (a professor of international economics at Harvard), “Low nominal interest rates help reduce debt servicing costs while a high incidence of negative real interest rates liquidates or erodes the real value of government debt.” So basically, when nominal rates exceed inflation—as they currently do in Europe and Japan—total debt is actually being reduced in real terms. For example, Europe’s CPI is running at 1.7% vs. a 1.1% yield on the average European Union 10Y note (an annual debt reduction of 60bps in real terms). Japan—the most indebted country in the world—has a CPI running at ~1% today vs. a nearly 0% (not a typo) 10Y JGB nominal yield (an annual real debt reduction of 1%). The Fed has been less aggressive, but Janet Yellen has previously guided to more QE in the event of another recession. How this will all playout, I have no idea. Nothing has snapped yet, but we are in uncharted territory.
I wonder if people will look back on the negative yields of today and ask, “what were they thinking?” There is an overarching complacency on the concept of credit and the path of interest rates going forward. Central banks are literally creating money with a few clicks of the keyboard, and it forces you to ask “what is money?” Too many people think: “if the Fed doesn’t want higher rates, we won’t get them.” Let’s say stocks tank 25%+ and Powell enacts “QE n”. You have to ask yourself what happens to faith in the US currency in that scenario. We have to look back to the 1970s when the market lost confidence in fiat currencies and the institutions that managed them (will look into this in more detail next week).
Interest rates tend to trend in generation-like cycles. Very few people have been around to see a bond bear market. It is very possible that interest rates could be going up for the rest of our careers. The bond bull market started in September 1981 and may have ended in July 2016. I’m not making a call for the world to end or some type of severe inflection in rates or hyperinflation. These same concerns could’ve been raised every year for almost a decade. I’m just saying that this is a crucial topic that all investors need to pay attention to and monitor closely.
Top 10 Reads of the Week
- WSJ: Where’s the Invisible Hand When You Need it
- WSJ: A Limit to China’s economic Rise: Not Enough Babies
- MIT Technology Review: Let’s Destroy Bitcoin
- WSJ: Trump’s Aggressive Trade Agenda Brings Heightened Tensions
- ZeroHedge: “Musk Meltdown”: Tesla Tumbles After Elon Cuts Off Conference Call Question
- Bloomberg: US Factories Are Showing Signs of Buckling From Demand Surge
- Barron’s: Exxon Mobil is a Bet on the Future of Oil
- Barron’s: John Doerr on Leadership, Education, Google, and AI
- The Economist: Trade Talks Expose a Chasm Between China and America
- Wired: CGI ‘Influencers’ on Instagram? They’re Only the Beginning