Monetary stimulus and its inadvertent effect on global financial markets.
Over the past number of years, tepid economic growth and the very real risk of deflation across the developed world has led to many large nations / blocs initiating large scale monetary easing policies, which have included both near zero interest rates and quantitative easing (QE) programs. This first begun in 2007 in response to the global financial crisis, with the Federal Reserve (Fed) in the US rapidly cutting interest rates in increments, from 5.25% to 0.25% over a 14 month period ending in late 2008.
Around this time the Fed also announced they would begin to engage in a debt purchasing plan which would ultimately result in a series of QE programs and only ended in October 2014, adding a massive $3.5trn to the Fed’s balance sheet (roughly the size of the German economy). Other developed nations followed suit with the EU initiating their own version of QE early last year with an initial commitment to pour a total of €1.1trn into the European economy through monthly purchases of €60bn worth of sovereign debt. This was later expanded to €80bn and allowed for the inclusion corporate debt. Similarly Japan has as recently as late 2014 expanded their own version of QE – affectionately named Abenomics (after Prime Minister Shinzo Abe) – to ¥80trn ($700bn) annually.
The unintended economic effect of all this excess liquidity has been inflated asset prices on the back of somewhat muted economic fundamentals, with South Africa being no exception. This has led to the massive volatility spikes in asset prices we have had to become accustomed to in recent years. What’s important to note here is that often these price jolts are on the back of the expectation of future events(tone of comment from the Fed with regards to the pace of interest rates hikes; flares in geopolitical tensions in the Middle East impacting potential supply of oil etc.) and not the actual events themselves.
With global developed bond yields now at historic lows, in some cases negative, investors are searching for yield in emerging and equity markets. When whispers emerge of increased risk in these markets, be it through poor Chinese trade data or heightened possibility of a Greek debt default, we often see a so called large scale flight to ‘safety,’ where investors sell out of risky assets and move into more stable often dollar denominated assets, which leaves emerging markets at the mercy of global sellers.
The notion of negative bond yields is a little perverse. Why would you hand a nation your money, only to receive less than what you gave them – ten years down the line? This doesn’t even take into account inflation and the loss of purchasing power. The fact of the matter though is that there is a market for this debt, with investors satisfied to take on such a return – or lack thereof.
The Economist summarizes these investors into three main groups:
- Those who have to own government bonds, i.e. central banks; insurance companies; pension funds etc.
- Those who are buying the bonds with the expectation of making money off currency movements. Think a US investor buying yen denominated Japanese sovereign debt who holds the view that the yen will appreciate against the dollar.
- Finally, those who are content with the small loss offered in these bonds as opposed to a potentially much larger loss in a more risky asset class. With European equities off some 20% over the last year, one could not have been called a fool for ‘locking in’ a relatively respectable -0.5% on a one year EU bond. This of course comes with the caveat that no one can accurately predict asset class returns over any meaningful period.
What then do negative bond yields mean for other asset class valuations? Historically when referring to the risk free rate, widely used in asset pricing models, we would look at the three month US Treasury bill, or developed market local equivalent. With Europeans locking in a ‘risk free’ -0.59% and the Japanese basing valuation models off a stable -0.48%, has our definition of what is risk free become somewhat mutated? Perhaps not. In essence what is risk free is not the guarantee of a positive real return but rather the limitation (to zero) of volatility. At the end of the day, there are investors willing to pay for stability.
The expectation has long been, since the start of QE, that these expansionary monetary policies would ultimately reignite sustainable economic growth and coax target inflation out of hibernation. However, this has not been the case, as even after almost a decade of pumping the economy with free money and creating a near zero cost lending environment, we haven’t seen the global economy fire up again. This can be blamed on a number of unfortunate global mini-crises – i.e. European debt crisis; commodity slump; Chinese growth slowdown etc. but at the end of the day interest rates have to normalize at some stage in spite of some structural shifts in the macroeconomic status quo. When this will happen is anyone’s best guess.
The next, and rather drastic, option being flouted around European Central Bank (ECB) meetings is the U.S. Nobel laureate Milton Freidman concept of ‘helicopter money.’ One such scenario which could play out in this system is the direct transfer of funds to citizens, funded through the printing of money by central banks. How this differs from conventional quantitative easing is the asset swap principle, whereby under QE central banks are exchanging capital for other assets such as sovereign, or in certain cases corporate, bonds.
Under the helicopter drop of money there is no value retention for central banks, but rather a direct attempt to influence aggregate demand as opposed to hoping for a trickle-down effect from financial markets. For the moment though, both Japan and the EU have expressed resistance to such a strategy, with the president of the German central bank Jens Weidmann calling the idea “absurd.” Absurdity aside, one thing is for certain; in a world of negative interest rates and sub-zero long term bond yields, Central Banks are running out of ammunition in the attempt to reinvigorate the global economy.
On another note, which ties nicely into an article we wrote about the effect of a downgrade to junk a couple of weeks ago, South Africa recently finalized the issue of a $1.25bn 10 year Eurobond* at a rate of 4.875%. The bond, priced in US dollars, yields a return that is 3.35% higher than that of the equivalent ten year US Treasury benchmark bond. That spread is what we allude to when we discuss credit default swaps, or the added risk placed on South African debt due to the risk that the government will not be able to honour their obligations. When we wrote on the effect of the potential downgrade we argued that a lot of the effects of junk status were already priced into the cost of borrowing for the South African government.
This is evident in the price that foreign investors are demanding to invest in South Africa’s sovereign debt, which at that price rates the risk of default at that of other junk rated nations. Therefore, to reiterate our thesis, when you hear a man in the street proclaiming the apocalypse if South Africa is downgraded later this year by one of the three big agencies to junk, breathe deeply and be to some extent comforted in the fact that the market is usually a pre-pricing machine and large scale gyrations are usually on the back of shocks to the system and not somewhat expected events.
*Eurobond is a foreign denominated debt instrument, not necessarily priced in euros.