Welcome to the Negative Interest Rate World

Dear PGM Capital Blog readers,

In this weekend blog article we want to elaborate on the fact that the value of negative-yielding bonds – both government and corporate – swelled to US$13.4 trillion this week as negative interest rates and central bank bond buying ripple through the debt market.

In market economies, money is the measure of the value of goods and services, and the interest rate is the price of money itself. When the price is zero, it makes no difference whether money is kept under a mattress or lent, because there is no cost to holding or borrowing cash.

Policy makers in both Europe and Japan in order to prevent their respective economy to slide back into deflation, or a spiral of falling prices that could derail the economic recovery, chose to experiment with negative rates before turning to a bond-buying program like those used in the U.S.A.

But how can the price of money – which, after all, makes the world go round – be zero? And how can it possibly ever become negative?

Negative rates means that the lender pays the borrower for the privilege of lending money.

Yes, you read that right. You lend money to an entity and will not earn any interest. In fact, you will get back less money than you lent when the bond matures, which is where the ‘negative’ part comes into play.

Only bad things, like toxic waste, have a negative price, the equivalent of a fee payable to anyone willing to make them disappear. Does this mean that negative interest rates embody a new perspective on money – that it has gone “bad”?

The talk of negative rates has spread also to the USA, with Fed Chairwoman Janet Yellen, failing to take them off the table, at a recent congressional hearing.

Negative interest rates are an act of desperation, a signal that traditional policy options have proved ineffective and new limits need to be explored. They punish banks that hoard cash instead of extending loans.

History never looks like history when you’re living through it, but this is the first time in at least 5,000 years we have driven interest rates below zero.

If you were dropped to earth for the first time ever, how would you objectively view the current 10-year government bond yield environment?

  • USA: 1.36% on July 5, the lowest level in American history
  • Great Britain: 0.52%, on August 12, a 322-year low
  • Japan: -0.27%, on July 27, 2016, the lowest level in Japan’s history
  • Germany: -0.17%, record low on July 8, 2016
  • Italy: 1.03%, on August 12, 2016, the lowest level in Italy’s history
  • Switzerland: -0.63%, record low on July 11, 2016

With this low to negative yields, Investors have to take bigger risks if they want to returns of 2 decades ago.

Below chart shows a portfolio breakdown of an investor in 1995, 2005 and 2015, who want to have an average return on investment of 7.5 percent per year.

Bond guru Bill Gross of Janus Capital thinks the surge in negative yielding bonds around the world will have dire consequences:

“Global yields at lowest in 500 years of recorded history. US$10 trillion of negative rate bonds. This is a supernova that will explode one day.”

The World Gold Council is more gentlemanly about it, in a statement they’ve said:

“Bonds generally help balance the risks inherent in portfolios. Low yields, however, not only promote risk taking, but also limit the ability of bonds to cushion pullbacks in stocks and other risk assets in investment portfolios.”

We believe that the surge in demand for bonds has pushed prices and valuations into bubble territory. Investors should be reminded that Bubbles never last and that Sooner or later, a crash is inevitable.

Which means, that if you take away the safety and yield on Treasuries, what do you have left?

An I.O.U. from a central banker.

Based on this we believe that any responsible investor has to keep in mind that the bond market is roughly twice the size of the stock market, excluding derivatives, which means that an exodus could get ugly.

History shows that gold has been part of every major financial reset, since at least the Roman times. It will be no different this time.

Despite what you may think about gold, it is a 3,000-year safe haven that has zero default risk, is just as liquid as a bond, and will be a natural landing spot for beat-up bond and equity investors. And if held privately in physical form, it has no counterparty risk.

Last but not least, before following any investing advice, always consider your investment horizon, risk tolerance and financial situation and be aware that markets can remain longer irrational than that you can remain solvent and that prices of precious metals and the stock of their producers might be very volatile and that sharp corrections may happen in the short term.

Until next week.

Yours sincerely,

Suriname Times foto

Eric Panneflek

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