Voices: Is Pimco right that negative yields make sense?
It’s longer retirements, stupid.
That, in a nutshell, is why negative bond yields might not be a nonsensical bubble ready to burst but actually natural, according to Joachim Fels, Pacific Investment Management Co.’s global economic adviser. More people in developed economies are living longer and need to save for decades of retirement, which, according to Fels, is causing a radical shift in how people prioritize immediate spending compared with future consumption.
In a blog post this week on Pimco’s website, he laid out perhaps the most concise and straightforward case I’ve seen yet for what structural changes are behind this phenomenon of paying for the privilege of purchasing debt:
Once upon a time, economic theory maintained that people always value today’s consumption more than tomorrow’s consumption — and thus display positive time preference. People would therefore always demand compensation in the form of a positive interest rate in order to forgo current consumption and save for the future instead. People were viewed as impatient, and the more impatient people are, the higher the interest rate has to be to make them save.
This made sense in a world where people usually died before they retired and struggled to satisfy basic needs. However, it can be argued that in affluent societies where people can expect to live ever longer and thus spend a significant amount of their lifetimes in retirement, more and more people demonstrate negative time preference, meaning they value future consumption during their retirement more than today’s consumption. To transfer purchasing power to the future via saving today, they are thus willing to accept a negative interest rate and bring it about through their saving behavior.
Now, this notion of negative time preference alone isn’t enough to justify nominal yields falling below zero. Without question, the policies of global central banks play a leading role in redefining the lower bound for interest rates. The fact that the European Central Bank is willing to purchase an assortment of debt at any price is undoubtedly distorting the bond markets within the region. For instance, 10-year Spanish debt is yielding a record-low 0.13%, compared with more than 7% in 2012. Ten-year German bunds reached an all-time low of -0.6%. Even some European junk bonds, which by definition carry massive default risk, yield less than zero.
And, to be sure, it’s still too soon to say his final conclusion — that people are “willing to accept a negative interest rate” to transfer purchasing power to the future — will stand the test of time. It’s true that bonds with sub-zero yields have been around for years and that the pile has now grown to a staggering $15 trillion. But as I wrote recently, much of that debt was issued with a positive interest rate, and those buyers have seen sharp price appreciation as a result. The true test is still to come when countries and even companies try to sell securities that pay no interest at a price above face value, guaranteeing a loss if held to maturity.
Still, Fels’s point is the logical conclusion of taking the savings glut argument to its extreme. If trillions of dollars are out there seeking something as close to a riskless investment as possible to preserve investors’ wealth, then why shouldn’t the entire German yield curve yield nothing, or even less than nothing? The Federal Reserve’s gradual interest-rate increases over the past few years have kept Treasury yields firmly positive, but if Chairman Jerome Powell and others capitulate and cut rates even deeper, it stands to reason that the benchmark 10-year U.S. rate will quickly approach zero as well.
The idea that negative yields are a natural byproduct of the times is a contentious topic, and one that many market observers simply will not accept. Bloomberg News’ Joe Weisenthal has been on the forefront of this argument on Twitter, using the term “yieldbugs” to describe those who argue sovereign interest rates (or rates on savings accounts) must be positive. In recent days, both Mark Grant at B. Riley FBR and my Bloomberg Opinion colleague Mark Gilbert have compared the situation in the bond markets to Lewis Carroll’s “Alice in Wonderland” and “Through the Looking-Glass.” The idea being that the impossible is becoming possible.
I, too, have argued that negative yields could be the death of the bond market as we know it. It’s possible to agree with that and also concede that Fels makes a strong point. There may come a time in the not-too-distant future when investors don’t expect to collect fixed interest payments from sovereign debt obligations, nor do they expect to earn anything from parking their cash in a savings account. That’s no longer a bond market in the traditional sense. If that sounds like something of a “wealth tax,” that’s because it effectively is. The two choices are to invest in risky but potentially lucrative endeavors or to keep that money safe but have it erode slowly through zero or negative interest rates.
Unsurprisingly, those accustomed to firmly positive returns on bonds are balking at those two paths. That’s probably in part why gold is having something of a renaissance of late, trading above $1,500 an ounce on Wednesday for the first time since early 2013. Just as slowing global growth and the escalating U.S.-China trade war push down bond yields, they also increase demand for other traditional havens.
Fels ends his post by stating that Pimco expects the Fed kicked off a major easing cycle last week and that if the central bank cuts the fed funds rate to near-zero and restarts quantitative easing, “negative yields on U.S. Treasuries could swiftly change from theory to reality.” Indeed, some eurodollar options trades on Wednesday targeted negative U.S. rates in 2022.
It certainly seems as if the world is in a race to the bottom in yields, with New Zealand being the latest example of a country slashing rates to try to boost inflation and weaken its currency. “It’s easily within the realms of possibility that we might have to use negative interest rates,” Reserve Bank Governor Adrian Orr said.
Fight ultra-low bond yields all you want. Other investors are locking in what they can get right now — like a near-record low 2.15% on 30-year Treasuries — before interest rates disappear entirely.