Are Negative Interest Rates Coming to the U.S.?
Negative interest rates have affected bond investors around the world since the European Central Bank (ECB) was the first major central bank to implement them in 2014. What was originally intended to provide a short-term boost to the ailing European economy has increasingly turned into a permanent feature across financial markets, and the prevalence of negative interest rates appears to be spreading.
Global bond yields have collapsed this year as investors are growing more concerned that trade uncertainty is going to take a bigger toll on global growth than expected. This has caused the amount of negative-yielding debt to skyrocket. The Bloomberg Barclays Global Aggregate index, a widely followed global bond benchmark, currently has $15 trillion worth of bonds (down slightly from the peak of $17 trillion earlier this year) or over 25% of the total index trading at negative interest rates. This is unprecedented.
There are an astounding 35 developed countries around the world grappling with negative interest rates today. Nearly a dozen of these countries have their 10-year government bond yields trading below zero. This includes some of the largest countries represented in the Bloomberg Barclays Global Aggregate Bond index, such as Japan, Germany and France. Collectively, these countries make up nearly 30% of this widely-used global bond benchmark. When U.S. bonds are excluded, that figure soars to above 40%. The total amount of negative-yielding debt is even higher when other countries that are part of the European Union or have their currencies that closely follow the Euro (i.e., Sweden, Denmark and Switzerland) are included.
The broader fixed income market has not been immune to the spillover effects from central banks’ negative interest rate policy. Some segments of the corporate and mortgage sectors of the bond market are now trading with yields below zero as well. A chart from Deutsche Bank’s Chief Economist Torsten Slok shows just how swift the move has been this year. While the total amount of negative-yielding corporate debt represents less than 10% of the global bond universe, the unrelenting drive to lower and lower yields shows no sign of abating.
Source: Deutsche Bank
As improbable as it sounds, some junk bonds, or those bonds that carry the highest risk of default, are even trading with negative yields these days. Think about that: not only do investors have to pay for the privilege of owning “safe” government debt, but this environment has pulled yields on some of the riskiest of debt into negative territory as well. While the vast majority of corporate and high yield debt continues to have positive interest rates, it shows how pervasive this trend has been.
During normal times, investors are usually compensated for the risk that a company could default (in the form of additional interest). However, in today’s upside-down world, investors are guaranteed to lose money if they hold negative-yielding government or corporate debt to maturity. The key questions on everyone’s mind are will the low yields overseas pull U.S. rates into negative territory and what are the risks and implications for investing?
The idea of negative interest rates used to be unthinkable, but not anymore. The past decade has shown investors the extraordinary lengths that central banks are willing to go to in order to support their economies and ward off deflation risks. It has also demonstrated that the fundamental character of bonds, which have traditionally been an income-generating asset, may not be a given anymore.
While U.S. interest rates stand out in the yield-starved world, it remains to be seen how long the wide divergence between the U.S. and its overseas counterparts can last. Not only have interest rates around the world collapsed as fears of a global recession have risen, the value of the U.S. dollar has continued to soar relative to our trading partners. The effects of a stronger dollar on U.S. exports and emerging markets, which are reliant on global capital flows, are clearly negative for global growth.
Source: Federal Reserve Bank of St. Louis
If global economic growth continues to deteriorate, it is possible that U.S. policy rates could fall back to zero, or even turn negative like they are in much of Europe and Japan. This would likely drag yields across the maturity spectrum lower. While most fund managers do not expect this to happen, the past decade proves that anything is possible.
The Federal Reserve policy makers explored the possibility of using negative interest rates during the financial crisis, even though they ultimately chose not to implement them. With the swiftness in interest rate moves this year, even Alan Greenspan, the former Federal Reserve Chair, has commented that it is “only a matter of time” before the U.S. gets sucked into the global trend of negative-yielding debt. With the Fed’s limited flexibility to respond to another financial shock, it is probably safe to say that it cannot be ruled out.
Now that negative interest rates are well entrenched in the financial markets, investors have had to come to grips with the new environment. Some fund managers have embraced it, focusing more on relative returns to their respective benchmarks than absolute returns. Their logic is that while negative bond yields may not appear to be attractive at face value, they have more than made up for the lack of yield with the huge price gains they have had this year, as interest rates have fallen deeper into negative territory. Others have avoided investing in these countries altogether, favoring countries with higher positive interest rates.
While there is no consensus on what the future will bring, these powerful factors are likely to stick around a while longer, as discussed in our Lower for Longer article earlier this year. The longer the current environment persists, the more challenging it will be for the average investor to earn an attractive, positive return from their bond investments. However, now is not the time to give up on bonds. Bonds still act as a stabilizer in a portfolio when equity volatility spikes. This is true regardless of the current level of yields.
Note: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice. Opinions expressed are those of the author, and do not necessarily represent the opinions of Cammack Retirement Group.
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