Haselmann - Won’t Get Fooled Again

by Guy Haselman
Scotiabank
Feburaury 5, 2015

Central bank polices have ruptured the proper functioning of capital markets. Policy over-reach with gargantuan experimentation has, and continues, to fuel extreme mispricing of risk and mis-allocation of resources. Soaring market volatilities with wild daily gyrations are a symptom.

A battle is raging between the non-believers (doubters of policy success) versus those clinging to the hope that a soft landing can someday be engineered.  Some investors have little choice but to play along.  Some investors only participate reluctantly.  Yet, other investors move to cash or cash-equivalents, while looking for better ‘places to hide’.  For the growing number of non-believers, the secret sauce today is trying to find non-correlated sources of idiosyncratic risk where adequate compensation is offered for that risk.

So what do investors do in a ZIRP/NIRP world (Zero/Negative Interest Rate Policy)?  Why would anyone pay money to lend money?  Buyers are typically those who are mandated to do so: passive indexers, some bond funds, LDI pensions or insurance companies.  Some of them, however, are locking into losses that will at some point have terrible consequences (e.g., an insurance company who sold an annuity product several years ago that guarantees, say, a 4% return).

Investors who are not mandated, and who do not wish to lock into losses, are incentivized to take risk.  They either have to move out the curve, assuming duration risk, or they move down the capital structure, assuming credit risk.  Since investors only receive a trivial yield boost by increasing duration or credit risk, many investors have instead moved further up the risk spectrum to equities.  The justification is often, ‘equities have upside, while bonds are capped at par’: such a comment does not take risk into account.

QE programs turbo charge the chase for yield because central banks hoard the safest assets.  Those who sell securities to the central bank need to replace those assets, but reinvestment into an asset that yields a similar return often means moving into a riskier security.There are some fixed income managers who now get their fixed income exposures through dividend paying stocks.  Speculators who buy negative yielding bonds only do so in the belief that they will be able sell them at an even more negative yield.

With negative yields on some deposit accounts and on highly-rated securities, investors have to decide if they want to pay money for safety, or pay to avoid risk. Most decide to chase positive return (risk), causing many to extend beyond their historical risk preferences and for which many are ill-suited. Aggressive central bank activity and implicit promises have led to behavioral changes where investors have become fearful of missing out on the easy returns of markets that are perceived to rise perpetually (as long as the Fed doesn’t hike).

Finland became the first country to issue debt as long as 5 years in the primary market at negative yields. In the secondary market, Germany, Sweden, Switzerland and The Netherlands have negative yields on debt trading out to 5 years. Nestles became the first corporation to have a negative yielding bond.

As policy rates and bond yields plummet, and as equity markets power to new highs, investors need to recognize that future expected returns decrease, because (for the most part) rising markets shrink upside potential, while enlarging downside potential.  Nonetheless, some investors myopically believe that ‘money printing needs a home’ and that it will end up in equities (the asset class with upside).  However, such a belief needs to include a deep faith in the central bank’s abilities to navigate a soft landing.  History is not on their side.  Investors pouring into equities might be playing an epic game of chicken. 

There are significant consequences of ZIRP and NIRP.  Money market funds, pensions, insurance companies, savers, or those who live on a fixed income, are punished at the expense of the debtor.   Low rates imply less household disposable income for creditors and more disposable income for debtors.  Capital accumulation and savings - that would normally reduce overall debt levels – is discouraged.

The original premise behind the QE programs and other types of extreme monetary accommodation was to lower leverage and reduce the high levels of indebtedness that caused the 2008 crisis.  In this light, measuring the success of central bank’s extraordinary policies should include the progress made in lower indebtedness to safer levels.  Since global indebtedness has risen materially, it can be argued that levels of financial instability have actually risen and central bank policies are to blame.

Consultancy firm McKinsey & Co just issued a report finding that global levels of indebtedness have increased from $142 Trillion in Q4 2007 to $199 Trillion in Q2 2014 with debt as a share of GDP rising from 270% to 286%.  Debt is being added at a faster rate than GDP.  Policy makers are borrowing from the future to solve the short term problems of today. The result is unstable future outcomes and ballooning risks to market stability; concurrent with complacent investors unwittingly scramble for paltry returns.  Holding cash has never looked so good.

“We’ll be fighting in the streets / with our children at our feet / and the moral that they worship will be gone.” – The Who