How would you like to lock in a government guaranteed loss for the next 20 years? Most of you would brush off such a preposterous proposition as pure lunacy. However, investors in Japan are lining up today to answer that question affirmatively. It wasn’t so long ago that the concept of negative interest rates was relegated to whimsical fantasy and philosophical conjecture. Today, negative interest rates are found in many developed markets around the world, and the lock-in terms keep getting extended.
It started with central banks charging a small fee for holding your money overnight. Instead of paying interest on those holdings, like they had since the beginning of time, central banks tried to force cash into circulation by reversing the payment flow on borrowings. The concept was simple: Central banks thought no one would lend money (buy bonds) to any institution that guaranteed to return less than what they borrowed, and therefore investors would deploy their cash elsewhere. However, the central bankers have been proven wrong.
The European Central Bank initiated a negative interest rate policy (“NIRP”) two years ago. Since then, the Bank of Japan, Sweden, Denmark, and Switzerland have embarked on government-sponsored NIRPs. These typically involve only overnight and short-term lending. However, investors and market action have continually pushed the envelope.
Although the U.S. Federal Reserve has never ventured into NIRP territory, there have been a few instances when market action produced a negative yield for buyers of short-term U.S. Treasury bills. In other parts of the world, investors have extended the negative yield concept to longer and longer maturities.
In Germany, all government-issued bonds with short-term maturities have had negative yields for a while now, and about a month ago, the yield on German 10-year bonds went negative. Japanese 10-year bonds went negative in March, and earlier today, new Japanese 20-year government bonds were sold with a negative yield.
Think about that for a minute. When you buy a bond, you are essentially lending money to the issuer. Typically, the borrower pays interest and returns what it borrowed, while the lender receives the interest payments plus the amount it lent. Today, buyers of Japanese 20-year bonds essentially said, “we would like to lend you our money for the next 20 years, and you do not have to pay all of it back.”
Why are investors being so kind to the Bank of Japan? I honestly do not know. One theory is the “safety” of such an investment. Given that the Japanese stock market is still more than 59% below its value of 26.5 years ago, perhaps locking in a smaller loss for the next 20 years seems like the “safe” thing to do. Another theory is that deflation will make the transaction profitable. Under this scenario, if there is deflation over the next 20 years, then the reduced amount of returned cash will be offset by the greater purchasing power the less cash will have at that time.
Not to be outdone, Swiss government bonds now have negative yields on maturities out to 50 years. I will not be buying any bonds with negative interest rates, and I would encourage you to avoid them, too. Despite the potential for some “safety” and the hope of increased purchasing power, the guaranteed loss is more than enough to keep them out of my portfolio.
All sectors participated in the rebound of the past week and saw significant improvements in their momentum scores. Additionally, ranking changes were negligible, suggesting relative fairness in the advance. Utilities, Real Estate, and Telecom remain tightly bunched at the top for a second week. They are the three highest-yielding sectors, indicating a continued investor desire for income. Consumer Staples edged ahead of Energy in a tight race for fourth place. Health Care, Industrials, Materials, and Consumer Discretionary transitioned back to green. They spent only one week in the red, as the Brexit sell-off was short-lived. The changes left Industrials ahead of Materials, and Consumer Discretionary stronger than Technology. Technology failed to flip back to green and slipped a notch to 10th. Financials holds down last place for a third week.
The 10 lower-ranked style categories returned to green following a brief week in the red. Only Mid-Cap Value maintained its positive momentum throughout the recent turmoil, and its time at the top now encompasses 14 of the past 18 weeks. Improvements in relative strength rankings generally fell to the smaller-capitalization categories this past week, as Mid-Cap Blend climbed two spots, Small-Cap Blend improved a notch, and Small-Cap Growth moved two places higher. Value is preferred over Growth, with Value categories holding three of the top four places and Growth at the other extreme. Mid-Cap Growth slipped to 10th, and Large-Cap Growth is on the bottom for the seventh consecutive week.
Latin America re-exerted its strength and extended its lead over the other global categories. The improvement also pulled the broader Emerging Markets category up from third to second. Canada gained momentum but was forced to move a spot lower by the advance of Emerging Markets. China, U.S., Pacific ex-Japan, and World Equity were all in the red a week ago but are now back in positive trends. The U.S. climbed two spots to fifth in the process, and World Equity improved by one. The bottom four categories remain in the red. Japan did not rebound as strongly as other regions and slipped two places lower. The lowermost three are in the same order as last week, and all are suffering from the post-Brexit-vote fallout. The U.K. gained on EAFE but was not able to overtake it. The Eurozone is firmly in last place amid both currency and equity weakness.
“The downside risk for yields is in sharp focus, and the trend is showing no signs of letting up.”
—Souichi Takeyama, rates strategist at SMBC Nikko Securities Inc.
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