Borrowers pay interest to lenders for the use of their capital. At least that’s how it’s supposed to work. One of the most fundamental concepts in finance is the time value of money. That is the idea that a dollar today is worth more than a dollar tomorrow; consumption today is valued more than in the distant, uncertain future.
Time value of money is applied everywhere in finance, including predominant valuation models which “discount” future earnings streams to their present day value. When money can earn interest over time, it’s natural that money is worth more the sooner it is received.
But recent action in the bond markets is turning this concept on its head. Instead of borrowers paying interest to lenders, lenders are starting to pay interest to borrowers. “Here, take this money, I’ll pay you to hold on to it for a while.”
Sound absurd? It should, because that’s very different from what we’re used to. As odd as this may sound, we’re seeing it play out on a large scale.
Swiss debt recently hit a milestone, becoming the first government issued 10-year debt to carry a negative interest rate. Investors in this debt are content to pay the Swiss government to use their money for the next ten years. What does that say about their outlook for the global economy?
No investor willingly loses or gives away money. At least none that I know. Therefore investors pledging money at negative yields must be betting on one of two scenarios playing out.
The first is deflation. Deflation has the potential to turn a negative nominal (non-inflation adjusted) return into a positive real (inflation adjusted) return. If we do sink into an outright deflationary environment, this “protected” money could do well, growing the lender’s purchasing power even though the actual number of dollars received back from the investment are less than those set forth.
The other scenario is more short-term oriented, and it’s a bet that interest rates will go even lower. If rates do continue falling, it means bond prices will rise, providing a positive return. In a variation of the "greater fool" theory, this wager is placed on the hope that other institutional investors will be willing to accept an even greater negative interest rate in the future … a development that also implies a heavily deflationary environment.
Rates in the U.S. are very low — the yield on the 10-year is currently 1.94% — but relative to other counties, the yield is impressive. Every country in Europe sports lower rates, with the exception of Greece. Germany’s 10-year is barely in positive territory, at 0.16%.
The fact that yields across the globe are well below that of the U.S. has some key implications. First, longer-term yields in the U.S. are unlikely to rise significantly, as that would imply an even greater spread above other sovereign debt, which would boost demand for Treasuries, keeping U.S. yields in check. Low bond yields will also continue to support high equity prices.
I’ve mentioned in prior articles that I believe that when the Fed finally begins raising short-rates, it will not translate to the long-end of the yield curve, but will instead result in a flattening of the curve. This is a function of short rates being set by the Fed, and longer rates being set by the global market. We saw this phenomenon play out during the last three rate hike cycles. If you want a refresher, read my article here.
I think this will be a key relationship to understand moving forward, as it may tie the Fed’s hands with regard to how much they can tighten without throwing the economy into recession.
Another implication of foreign bond yields being well below those in the U.S. has to do with the dollar. The dollar will remain a key beneficiary of this demand for “high” yielding Treasuries, buoying the value of the dollar for some time to come. This of course has its own implications which have been widely discussed on this site.
This is a time when you, as an investor, should be more concerned about deflation than inflation. The smartest and most talented money managers across the globe are demonstrating through their behavior that deflation poses a much more ominous threat than inflation. Central banks have and continue to do everything in their power to stimulate credit growth, and the results have been paltry.
The preceding content was an excerpt from Richard Russell's Dow Theory Letters. To receive their daily updates and research, click here to subscribe.
Related:
Matthew Kerkhoff: Still No Sign of Recession or Bear Market
