After the Great Recession of 2008, negative interest rates emerged in The Euro Area, Switzerland, Sweden, Denmark, and Japan.
Given our uncertain economic climate and a renewed push by President Donald Trump, we foresee negative interest rates coming to the US.
US 10-year Treasuries sit at a yield of 65 bps, which means if you buy the bonds today and hold them for 10 years, you earn a whopping 0.65% a year if you hold to maturity. One of the mandates of the Federal Reserve is to maintain inflation at a steady 2% rate, so if they succeed, you lose 1.35% a year (technically negative). What would compel investors to buy bonds then?
One is relative value: It is better than owning 10 year German Bunds at -0.54%. European investors could move their money from Bunds to Bonds for higher yield, but they don’t because the Euro will likely weaken against the dollar at the rate of the spread.
The other reason is the total return on the bond trade, meaning that rates would have to go down enough to appreciate the market value of the bonds in order to sell at greater the rate of inflation. In order to match the rate of inflation, 10-year rates would have to decrease to 0.5%, appreciating the value of the bond by 1.45% (plus holding the bond for a year to earn a total return of 2.1%). Of course, simply buying US Treasuries (UST) and selling them every year after earning a rate of inflation is not a great strategy for 2 reasons: 1) you are not earning real money, and 2) you would have to roll your money into something new at the end of the year, likely bonds with lower yields.
The two largest groups of institutional investors are pensions and insurance companies, which broadly require an 8% and 6% return annually respectively to meet their liability-driven investment strategy (LDI) and actuarial assumptions to remain solvent and pay their beneficiaries. Insurance companies would require 10-year rates to drop to 0.11% within the next year to generate enough total return to make it worth it to invest in bonds. Pensions would need 10-year rates to go to -.08%. To use round numbers, in the next 18 months, rates will have to be between -.25% and -.50% to attract pension and insurance capital.
Pensions are a larger purchaser of equities than life insurance, but most pension models cap out and move to bonds when P/E ratios peak, as they are now, forcing into defensive assets.
Jerome Powell recently stated that he would hold rates positive but the Fed can only control the short end of the curve. Market forces will push the rest of the curve into negative territory. But the Fed may be forced to take the discount rate lower to keep investors coming into treasuries.
Effects on Equities
Equities are overbought. As we write, the S&P is at 2800. We believe that earnings will be close to 120 at best, which at a historical average multiple of 16, puts S&P fair value of 1920. Likely earnings will be 100, and given this is a worse recession than most, pushing a multiple of 15, pricing the S&P closer to 1500. Equities should continue to lose a sizable bid as institutions move to fixed income for safety and the above-mentioned price appreciation. This will have a negative effect on all risk assets, including pushing spreads wider on the lowest quality below-investment-grade bonds.
The last move up in the S&P, from a low of 2200 on March 23rd close, was mostly pushed up by retail. The buy volume for the last 7 weeks has been from retail online brokerages, giving larger institutional investors and funds an opportunity to get out of the equity markets. Now the longs are held by retail, largely weak hands, with no institutional bid. This leads to a greater market capitulation than we saw in March.
Real money has been moving out of equities and positioning for bond investing for the last 6 weeks. This will continue through the summer, pushing equities down and bond yields lower, and into negative territory eventually.
Effect on Banks
The fall in bank profitability can lead to a search for yield, and an increase in risk-taking by banks, which can have a negative impact on financial stability and decrease the beneficial effects of negative rates. The rate that commercial banks can charge on loans due to the lowering of interest rates allows for the ability to stimulate the economy however it also erodes bank profitability by squeezing deposit spreads. This is largely the reason why banks have not rallied over the last 6 weeks with the rest of the broad market.
Generational Bull Market (in Bonds) Won’t Die
Real interest rates have been declining since 1981 when it was north of 15% and the Fed has come to realize in the years that followed 2008, raising benchmark rates far above zero is not compatible with hitting its 2% inflation target.
The Fed’s mandate was holding inflation at 2% prior to the Great Recession, after which, a dual mandate emerged of 2% inflation and low unemployment. Now, a third mandate of maintaining markets has crept in. With low inflation, high unemployment, and weak markets, the Fed will cut benchmark interest rates to boost demand and investment, even if it means interest rates move to negative territory.
Implementing massive interest-rate cuts, and actually going negative, is a crisis response. This is a risky endeavor with a fallout that will plague markets for decades.
Steven McClurg — CIO
Leah Wald — CEO
Valkyrie is a discretionary global macro investment management firm. By analyzing fundamental macroeconomic, geopolitical, and social factors we are able to listen to the markets and effectively manage risk and generate alpha.
Valkyrie believes that shifts in government economic policies, political climates, currency exchange rates, international trade, international relations, and interest rates impact all financial markets. Utilizing this expertise of the global economy and financial markets, Valkyrie has constructed unique portfolios with a dynamic macro edge that includes exposure to emerging asset classes.
Together, Steven and Leah utilize macroeconomic strategy to structure and manage portfolios.
About Steven McClurg (CIO):
Steven McClurg is the Chief Investment Officer at Valkyrie. He was a managing director at Galaxy Digital, through the acquisition of his previous company, Theseus Capital, where he was a founding partner and CEO/CIO. Steven started his asset management career at Guggenheim Partners, a leading global investment and advisory financial services firm, where he was managing director and portfolio manager, including oversight of Emerging Markets and Sovereign Credit.
About Leah Wald:
Leah Wald is the CEO at Valkyrie. She was a Partner at Lucid Investment Strategies, an asset management firm specialized in investing in macroeconomic trends. Prior to joining Lucid, Leah was at Vital Financial analyzing investment strategies for Japan, Asia, Middle East energy, and global macro strategy. Leah started her career working at the World Bank Group reporting directly to the former Vice President of the Africa Region.
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