Negative Interest Rates, Decrees the Queen of Hearts!
Buckle your seat belts. This is going to get weird and metaphysical. My purpose is to turn the prism a little bit and try to make sense of something that I believe makes no sense. This would be a good time to get the children out of the room.
Currently, (Bloomberg 3-18-2016), negative interest rates prevail in many countries in Europe (ECB June, 2015 & Switzerland), Scandinavia (Sweden, Denmark) and in Japan (January, 2016), and Janet Yellen, Chairman of the US Federal Reserve, has intimated that they may be coming to a market near you if things don’t improve (November, 2015). Negative interest rates! All investing is a relative exercise of this versus that on an expected return continuum from zero to infinity. I like this, which yields X, better than that, which yields Y. Yes, I know this is riskier than that, but I am willing to accept this for this reason. “Yield” can be either literal (interest, dividend, cash flow) or implied (undistributed earnings yield, anticipated future distributions, sales proceeds). The slope of the continuum can tilt and undulate or even invert but “always” (up until negative interest rates) either begins or ends at, or approaching, zero. Generally speaking, as you go out in time, you would expect to be compensated more for renting (lending, investing) your capital. What the heck, then, is a negative interest rate? It means that if you deposit $1,000,000 in a bank, or buy a bond (make a loan), instead of being paid interest on your deposit/loan (rented capital), you must PAY to give someone your money. Say what? Alice has just fallen through the looking glass and the Queen of Hearts is setting the rules.
There is simply no way to explain this in a traditional sense. No one today has ever experienced this before now. There was a very brief period in the late 1930s when people were so terrified of collapsing banks during the Great Depression that they were willing to accept slightly negative effective yields on short term Treasury Bills (“Monetary Policy…”, Clouse, Henderson et. al., 11-27-2000). They were paying to store their money in a perceived safe haven instead of being paid for the use of their capital.
Have we violated immutable laws of economics and entered a fourth dimension? Bear with me while I digress. Two examples follow of a reality we inhabit, but very few of us can explain or really understand.
Superconductivity means that if you cool something sufficiently (minus 220F), a block of a special ceramic, which at room temperature could be an ashtray or a dinner plate and an excellent insulator of electricity (zero conductivity, i.e., no shock if you touch it, and it touches a live wire), actually becomes a perfect conductor of electricity (zero electrical resistance, i.e., it will fry you if you touch it). Imagine electrical current running down a ceramic “wire.” This breakthrough gave us, among other things, the MRI (uber X-ray machine), which I can’t explain but am very glad exists.
Second, Einstein’s Special Theory of Relativity (1905) postulates that the only thing that can travel at the speed of light is light (photons), which has no mass. As anything else with mass accelerates toward the speed of light, its mass approaches infinity, including a teeny tiny atom, electron, etc. Imagine that- an electron moving at the speed of light (which it can never attain), has more mass (infinite) than the universe. Well, you can’t imagine that. You just have to accept it. Einstein’s General Theory (1915) went on to describe space bending and time slowing and accelerating. You can’t imagine that either. Which naturally brings us back to negative interest rates. They violate the Laws of Economics and are just as hard to visualize, understand or imagine unless…
What if, as a consequence of the machinations of Central Banks the world over repressing interest rates in the mistaken (in hindsight) belief that low rates would reignite growth, those artificially low rates, in contravention of normal market forces, have opened up a worm hole to another dimension where low rates beget lower rates. Once you blow through zero on the interest rate continuum, you have entered a world where up is down and black is white. Through alchemy, we may have essentially converted financial assets (ideas) into commodities, which, by virtue of physical mass, must be stored. I told you this was going to get weird.
All things being equal, which they never are, the normal state of affairs in the commodity market is called Contango. If the spot (cash market for immediate delivery) price of, say, WTI (West Texas Intermediate) oil is $47/barrel, then you would expect that a contract for delivery of oil a month from now would be the current spot price plus the cost to store and insure the oil until delivery in one month. The further out you go in time, the higher the “futures” price should be. Backwardation, the opposite of Contango, would be prices declining as you go further out in time. Many people, including some practitioners and commentators, mistakenly believe Contango is a reflection of a market belief that prices are anticipated to rise in the future, as the price of a contract for delivery in six months is higher than today’s spot price (Dennis Gartman, Gary Shilling 2016).
If the steady state is Contango, what would it mean if oil (or any physical commodity) goes to Backwardation? Well, right now the world is awash in oil. The Strategic Petroleum Reserve is topped off full, as are virtually all oil storage facilities. In addition, some of the world’s oil tankers are now being rented as floating storage tanks, anchored offshore indefinitely. Contangos have been increasing (at the time of writing) as oil is “bidding” for storage and tank farms can demand higher and higher prices to store excess oil (Dennis Gartman 2016). This is hardly an indication of higher oil prices ahead, but rather the market pricing in excess supply.
Now imagine the opposite. We are running very low on oil. Demand is skyrocketing and supply is drying up. Business is desperate for oil and is bidding up the price of spot. Oil is needed now, not in three months. Because demand is so high, the owners of oil sitting in storage are delivering any excess they have over and above their future commitments into the spot market for cash today. The owners of the storage tanks have to cut prices to attract takers, even if it means they must store oil at a loss, just so they can generate some cash flow. The price of spot oil rises relative to deferred delivery contracts due to demand.
What does this have to do with negative interest rates? We have low interest rates because we have had anemic growth and low inflation for a very long time. Since negative interest rates make no obvious sense, what could they possibly be signaling? Gary Shilling has been saying for many years that the world is in a period of structural deleveraging after an extended period of increasing debt everywhere (“The Age of Deleveraging,” 2011). Deleveraging is inherently deflationary. When you pay off a loan, that money that was created out of thin air when the bank made you the loan, via the money multiplier, vanishes from the system (the money supply shrinks by that amount, as it had likewise increased when the loan was made).
Milton Friedman theorized that inflation is always and everywhere a monetary event, i.e., too many dollars chasing too few goods produces inflation (“The Counter-Revolution in Monetary Theory,” 1970). If this is true, then its inverse must also be true. Too many goods chasing too few dollars must produce deflation. I think it’s fair to say that most people have assumed that all the money the Fed (and Central Banks the world over) has pumped into the economy since 2007 must ultimately create inflation. That it hasn’t is one of the great dog that didn’t bark puzzles of recent times. But, what if the theory remains spot on, and it is we who didn’t see what is hiding in plain sight. When the Berlin wall came down in 1989, kicking off the greatest explosion in global trade in the history of the world, the result has been a tsunami of goods and services available to everyone everywhere that has dwarfed what seemed like massive amounts of dollars, euros, yuan, yen and any other currency you care to consider. Too many Toyotas chasing too few dollars drives prices down. What, anytime soon, will change that dynamic? Even natural resources are apparently infinite, for all practical purposes.
In addition, the very foundation of the idea that the Fed has flooded the system with dollars bears a little more scrutiny. While quantitative easing (QE) was certainly unprecedented in size and scope, the dollars created so far have not moved out in any size beyond the accounts of member banks at the Fed. They have significantly increased the reserves of those banks (Federal Reserve Bank of Cleveland, 2-12-15), and that is, in fact, money creation, but the real juice to M2, the money supply, comes when those banks then lend out those reserves. This money multiplier is money creation on steroids, and so far in this recovery the multiplier has collapsed for a variety of reasons beyond the scope of this article.
So, are negative interest rates telling us that in a world of virtually limitless goods and services, the natural tendency of prices is down, not up? With fertility rates in both the developed and emerging markets collapsing, there is no demographic surge of Baby Boomers on the horizon to generate demand and scarcity (World Bank, 2015). Negative interest rates in a sense transmute currency itself into a quasi commodity, valuable in and of itself, not just as a medium of exchange. In an uncertain world, perhaps people are coming to view dollars, euros, yen etc. as intrinsically valuable, like gold is perceived to be, worthy of storage and safekeeping, and are willing to pay for those services. Of course, in a more normal world, with interest rates materially above zero along a more normal curve, paying to store your dollars would make no sense. We would be back to the return continuum from zero to infinity. But as rates pierce the zero barrier into negative territory, and with deflation either here or just around the corner as many are coming to believe, paying for storage is not so irrational after all, since those dollars will buy more, not less, next year than they do this year.
Finally, there are two kinds of deflation — good and bad. Bad deflation is what is keeping central bankers up at night. It is when prices are falling because of lack of demand. Producers are reluctant to produce because they cannot recover their costs, much less make a profit. It is pernicious and very difficult to arrest because people come to expect prices to fall, and therefore they continue to defer purchases and save. Excessive savings paradoxically can be a very bad thing.
Good deflation, which is what I think (hope) is at play, occurs when there is so much innovation and technology creating so many new exciting products and services that people still want to buy them now, even knowing the price will fall in the future. They want the benefits now, in spite of falling prices, because they believe the future abounds with opportunity (ergo dollars), and they are optimistic things will continue to improve.
So, what does all of this mean, and what’s an investor to do? The honest answer is I haven’t the foggiest, and neither does anyone else. Pontifications about what the future will hold are the domain of fortunetellers. That stipulated, after 39 years of doing this, I have come to this conclusion. Deep down in our souls, each of us holds some core beliefs. We are either essentially optimists (probably a minority) or pessimists (probably the majority). Which we are will in large measure govern which investment views we will hold. Like growth investors versus value investors, both can win over time, but what won’t win is clambering onto the growth train after it has been ascendant (and is about to derail) and then abandoning it in the smoking rubble for the value train, which is now ascendant. A few round trips of this philosophy, and all you will have left of your net worth is smoking rubble.
With the possible exception of a very few talented investors who happily possess a gift, the solution to this problem, which is baked in the cake of the human psyche, is to diversify across asset class globally and then go fishing. Forget about beating an index. It’s amazing how many people are supernaturally fixated on the returns of an index, when the far greater threat to their financial security is coming into or out of an investment at the wrong time. Since market timing is impossible in the long run (except for the chosen few), carefully determine the correct asset allocation for you, based on your age, goals and psychology and then implement and forget it. If you are confident you can do this yourself, then by all means do it and feel free to index to achieve it. If you need help navigating the maze and want someone to advise you on this and the myriad other issues that arise throughout your life, then do your homework and find an advisor you are comfortable with and recognize the relationship must be mutually beneficial financially, just like everything else in life.
All of this said, I choose to be an optimist and believe we will have good deflation and a bright future. What I have going for me is the sweep of the history of human affairs which, with setbacks here and there, has always ultimately marched forward toward bigger and better things. This time will be no different. That’s my story, and I’m sticking to it.