Is it madness or fear at work?

Tuesday, 16th July 2019

Is it madness or fear at work?

I need a favour and I wonder if you can help me out….

I’m a little short of the folding stuff at the moment and it would be a great help if you could see your way fit to lending me £5000….

Don’t worry. I will pay you back. That’s for sure….

And better still, I won’t charge you an exorbitant rate of interest for giving me the loan….

You can lend me the full sum and it will hardly cost you any money at all….

Does that sound like a good deal?

No, I didn’t think so….

But that’s the kind of deal that’s being done with increasing frequency in bond markets right now….

  • What’s happening?

Under normal circumstances when investors lend money to governments, the government will not only undertake to pay the principal capital back after a fixed-term – but will also pay what is called a ‘yield’….

That yield is the interest – the price the government pays for the privilege of borrowing the capital in the first place….

As I say, that’s what happens under normal circumstances….

But circumstances are anything but normal right now….

Emergency interest rates – ground-floor interest rates – were put in place globally a decade ago to deal with the fallout from the last financial crisis….

And they are still in place. The emergency hasn’t really gone away. We’ve had a whole decade of the lowest interest rates ever known to man….

And those rates show no signs of returning to normal….

The Americans tried moving in that direction late last year and almost crashed the stock market. The time wasn’t right.  The patient wasn’t fit and ready for the treatment. The Fed had to reverse course….

President Donald Trump – a self-confessed ‘low interest rate person’ – has relentlessly banged the drum for even lower rates than we’ve seen across the last decade. He wants to keep the stock market climbing….

And Fed chief Jerome Powell appears to be bending to the pressure. This week he said that ‘….monetary policy hasn’t been as accommodative as we had thought….’

In other words, he’s saying that the rate should have been lower than it has been – not higher. He is effectively signaling to the market that he intends to go that way….

  • The trend towards lower rates….

The global trend towards ever-lower rates of interest can be seen clearly in the bond markets where negative yields are becoming commonplace….

Let’s be clear about what this means….

It means that governments are creating fixed-term bonds where the investor pays the government to take his capital….

It should be the other way around. The government should pay the investor. But negative interest rates turn the whole shebang on its head….

Buying one of these bonds is a bit like putting your money into a savings account for a fixed term at your bank and then paying the bank to keep hold of that cash for you….

At the end of the fixed term, you’ll have less capital than you started with….

What kind of deal is that? It sounds like something that might be dreamt up in Nigeria or by some dictator in a South American banana republic….

But it is first-world governments that are issuing these bonds….

Right now, you can buy 10-year bonds paying a negative rate of interest from the governments of Austria, Denmark, Finland, France, Germany, Japan, the Netherlands, Sweden and Switzerland….

  • Who would buy these things?

That’s the million-dollar question….

Who the hell would buy these things?

You would surely have to be stark raving mad to buy into a financial instrument that promises to erode your capital over the long-term?

Only a moron would take that course of action – right? Surely, the smart money would be put to work in the stock market….

Particularly the US stock market….

After all, Donald Trump keeps on telling the world that America is one hell of a success story right now….

And he should know. It is ‘Donald Trump’s economy’ after all. He’s the guy making America great again – ‘smashing expectations’ and ‘delivering for American workers’….

And ‘Donald Trump’s stock market’ underlines the point. Just last Wednesday the three main US stock market indices – the Dow Jones, the S&P 500 and the Nasdaq – all hit record intra-day highs….

It is boom-time in America, isn’t it? That’s what the stock market is telling us….

And with Fed chief Jerome Powell signaling his willingness to lower interest rates on the road ahead, the US markets are surely set for greater heights still….

Dow 30,000 might finally be reached, after all….

And even with markets not quite so buoyant in Britain and Europe and elsewhere, surely stocks are a better bet than negative rate bonds?

Surely it is better to invest in something where there is at least a chance of some return rather than something where you are sure to lose?

  • But let’s look at this differently….

But might we be looking at this the wrong way?

At first sight these negative rate bonds appear to be ludicrous inventions – something you might expect to read about in an Orwellian novel about a dystopian future….

And the investors buying these instruments might appear to have lost their minds in taking a deal that reads so badly on paper and makes so little sense when taken at face value….

But I wonder is there something else going on here? Are we reading this correctly?

Investors have to do something with their capital….

And sure, they could stick it into the stock markets that have been riding high for 10-years now….

But in choosing to invest their capital in government-issued negative rate bonds, could it be that these investors are choosing to guarantee themselves a small loss on their capital over the next 10-years rather than risk a massive loss should the markets crash….

Might the investors taking these 10-year deals with the French and the German  and the Swiss governments look at the negative yield as the cost of insurance against greater losses still….

In other words, might capital flight into negative rate bonds be interpreted as a sign of growing investor fear? Could it be a sign that investors are becoming more averse to risk in the stock markets?

I don’t know. Maybe the investors buying these bonds have simply lost their marbles and there’s nothing more to it than that….

But I’m not so sure. It could be a sign – one among many – that confidence is diminishing and that investors are going onto the defensive….

That’s the truth of it as we see it….

All the best,

Dave Gibson

Money Truths