One might define absurdity as the quality or state of being ridiculous. Or one can glance at the global quantity of negative-yielding debt.
The total? Nearly $14 trillion.
Holding a bond to maturity that pays a negative return is insane. Wouldn’t risk-averse folks prefer a 0% return that would come with the embrace of physical cash?
Unfortunately, central banks do crazy things. The euro deposit rate is at -0.4%. That means savers and investors could lose more money at a bank than with ownership of intermediate government debt, particularly if that deposit rate is pushed southward. Moreover, a physical vault for euros, yen and greenbacks is impracticable.
What about assets with higher yields or better total return prospects? Like junk bonds, preferred stock, dividend-producing stocks or growth stocks.
Granted, the riskier assets are far more appealing from the return side of the ledger. But the risk of experiencing declines of 50%-plus in a calendar year or two is real. It happened twice in this century alone; it happened despite the best efforts of the world’s central banks to prevent collapses in Europe, Asia and the United States.
Investors are left to make extremely difficult choices. “Risk-free” government bonds and the highest quality corporates may have limited downside with central banks scooping them up to permanently depress interest rates. Yet outside of trading bonds for a profit, inflation-adjusted returns may be “return free.”
Meanwhile, moving further and further out on the risk spectrum might provide decent returns. Then again, it may lead to disastrous loss of principal that is not guaranteed to recover quickly enough for near-retirees and retirees.
The concerns become more palpable with objective analysis of fundamental valuation. Nothing about U.S. stocks, at least, would suggest that they are reasonably priced. Bring the facts to the forefront, however, and you’ll be assailed by the euphoric “buy, buy, buy” crowd for failing to understand the awesome nature of ultra-low interest rates.
Are stock gains only about the negligible cost of money? Not historically.
The U.S. had a low rate environment for nearly 20 years (i.e., 1935-1954) that is very similar to the current low rate borrowing environment. During those 20 years, valuations were about HALF of what they are today.
People do not wish to discuss stock prices, stock valuation and interest rates in the 20-year period of 1935 to 1954. Indeed, if ultra-low rates were not enough to DOUBLE the “P” relative to the “E” back then, why assume that ultra-low rates justify exorbitant valuations here in 2019?
There’s more. The incredibly low cost of money from 1935 to 1954 did not prevent stock bears from taking place in 1937-1938 (-49.1%), 1938-1939 (-23.3%), 1939-1942 (-40.4%), or 1946-1947 (-23.2%).
Tomorrow, the U.S. Federal Reserve is looking to depress the cost of borrowing once again. Committee members will let dangerous levels of consumer, corporate and government debt become even more dangerous rather than be blamed for severe asset price depreciation. (They will be blamed anyway, but they’re hoping to delay the inevitable.)
Blow the bubbles bigger. Kick the containers down the road. Apparently, this is preferable to an immediate erosion of the wealth effect. Powell discovered his preference in the 4th quarter of 2018.
Not to be outdone, the mainstream financial media will put a stamp of approval on rate cutting activity as insurance. But what will the rate cut/series of cuts and the maintenance of an elevated balance sheet ($3.8 trillion) insure? That asset prices will reside in the cosmos forever? That the U.S. economy will never experience another recession?
The truth is, the Fed is losing control. It is the bond market – the global bond market – that is running the show.
Here is a chart that shows that when market rates start falling, the Fed starts cutting. Not the other way around. (And the initial “insurance cut(s)” did not help prevent the 50%-plus stock beatings of 2000-2002 and 2008-09, let alone halt the recessions.)
With the 10-year U.S. Treasury yield dropping from 3.2% down to the 2.0% level, and with the 10-year dropping below and staying below the Fed Funds rate, and with more and more bond yields turning negative worldwide, the Fed is playing catch up.
This has nothing to do with inflation expectations, or even trade wars and tariffs. This has to do with the bond markets collectively screaming at the Fed from the rooftops.
Perhaps ironically, the debate is not about whether or not the Fed should cut. The debate is centered around 25 basis points or 50 basis points, as well as how far to cut in 2019 and beyond. Equally critical? Communicating when the Fed intends to effectively kick start quantitative easing (QE) again, as the Fed will now be reinvesting electronic credits from maturing bonds in its portfolio.
So how will stocks, bonds and other assets respond to the Fed decision? I believe that the Fed will under-deliver, effectively disappointing growth stock enthusiasts. It will be 25 basis points and a whole lot of vague references to “data-dependence.”
The likely result? Bond yields will continue to drift lower over the weeks ahead, compelling the Fed to cut again in the near future. This will be positive for yield sensitive assets like iShares Core Treasury (NYSE:GOVT), Van Eck Preferred Ex Financials (NYSE:PFXF), Invesco S&P 500 High Dividend Low Volatility (SPHD) and Vanguard Real Estate (NYSE:VNQ).
While the near-term may see the S&P 500 struggle for direction, if not correct 4%-5%, the promise of future Fed stimulus may keep broader market indexes from dropping further. At least for now.
Again, my exposure will be prudently cautious, until total Fed capitulation meets genuinely attractive valuations. That’s right. I will wait for zero percent rate policy/negative rate policy and “shock-n-awe” QE initiatives from the Fed before becoming more aggressive in equities.