Negative Interest Rate Policies Are Dangerous To Your Wealth by Chris Brightman, Research Affiliates
- Investors are wise to be concerned by zero and negative interest rate policies promulgated by central bankers, because starting yields predict future investment returns. Zero real interest rates predict zero real returns, and negative real interest rates predict negative real returns.
- For long-term investors, risk is more about failing to meet wealth accumulation goals than about short-term changes in the price of their portfolios; thus, the more appropriate measure of risk is the estimated probability of reaching or failingto reach the desired or needed long-term real return level.
- Given the new negative interest rate policies environment, investors may wish to look beyond a traditional 60/40 portfolio to a portfolio holding substantial allocations in non-U.S. equities, alternatives, and credit.
Negative interest rate policy, or NIRP, is the most recently deployed weapon of central bankers in their long campaign of financial repression—a deliberate policy of depressing interest rates in order to transfer wealth from savers (private citizens) to debtors (largely governments). Financial repression is intended to improve near-term growth by encouraging consumption and discouraging savings. Why save today if your money will purchase less tomorrow?
Whether NIRP will produce the results intended and/or create unintended problems is not the subject of this article. Rather, we discuss how investors may wish to alter their investment plans to take account of the changes in expected returns both within and across capital markets given the new NIRP environment.
Abandoning ZIRP for NIRP
Many investors are understandably unnerved by news of negative interest rate policies. In Europe and Japan, monetary authorities have concluded that zero interest rate policy (ZIRP) has been insufficient to meet their inflation targets. Consequently, the European Central Bank and Bank of Japan replaced ZIRP with NIRP in June 2014 and February 2016, respectively.1 Government bonds issued by these governments, and some corporate bonds in these markets, now trade at negative yields. The Fed has not (yet) deployed negative interest rate policies but is actively discussing it. In a Congressional hearing on February 11, 2016, Federal Reserve Chair Janet Yellen said the Fed is “taking a look at them [negative interest rates]…I wouldn’t take those off the table.”2 In addition to the eurozone and Japan, the central banks of Denmark, Sweden, and Switzerland have also adopted a negative interest rate policy.
In years past, economists generally dismissed negative nominal interest rates as a mere theoretical concept. In the real world, went their reasoning, rates were bounded at zero because savers would store cash in a vault before they would endure a negative interest rate. As the Swiss National Bank demonstrated in December 2014 when the institution lowered its deposit rate to ?0.25%, the cost of storing cash is the actual lower bound for nominal interest rates. Nominal interest rates, we now learn, can fall to ?1.00% or more before savers will abandon their bank accounts for physical cash.
Ten-year real return forecasts3 are a valuable input to long-term investment planning! For investors who establish and stick to long-term plans and are able to persist with those plans over multi-year periods—for those with the conviction to increase positions that have disappointed over recent years—read on. Traders beware. Long-term return forecasts can be worse than useless for those looking for a trade. Over periods of months (and even a year or two), such forecasts are not much better than random noise. Frequent trading on such signals will enrich your broker, not you.
Negative Interest Rate Policies and Returns
Real interest rates (nominal interest rates minus the inflation rate) determine the growth in real purchasing power from investing in bonds. Real cash rates have been negative across the developed world since the global financial crisis in 2008. Today, real bond yields are negative in longer maturities too: out to 5 years in the United States, past 10 years in the the United Kingdom and the eurozone, and across the entire yield curve in Japan, as shown in Figure 1.
Investors have good reason to be concerned by ZIRP and NIRP because starting yields predict future investment returns. As we observe in Figure 2, the starting yield on the 10-year U.S. Treasury note has provided a highly accurate forecast of the subsequent 10-year return for those investing in the note. Consistent with this observation, zero real interest rates will predict zero real returns, and negative real interest rates will predict negative real returns
The strong predictive relationship between starting yield and subsequent return is not limited to the 10-year U.S. Treasury. The same predictive relationship is apparent for the broad investment grade bond market (U.S. Aggregate Bond Index), shown in Figure 3, as well as for 10-year sovereign debt of other developed countries. The figure plots this relationship for the United Kingdom, Germany, and Japan.
By our calculations, ZIRP and NIRP have depressed the expected real returns of core bond portfolios to within the narrow range of ?1% to +1%. Fortunately, government bonds are not the only choice for fixed income investors. For those willing to substitute credit asset classes for core fixed income, our current estimates of expected returns are more attractive. At the end of the first quarter of 2016, our forecasted 10-year expected real returns (in unhedged U.S. dollars) ranged from ?0.56% for long-term U.S. credit to 4.80% for local emerging-market debt. Figure 4 displays our expected 10-year risk and real return forecasts for 16 U.S. and non-U.S. fixed income sectors and the U.S. cash rate.
To be sure, asset classes such as bank loans, high-yield bonds, and emerging market debt require the investor to bear credit risk, but the yield spread over the comparable-maturity government bond provides compensation for this risk. Investors may find credit spreads and the corresponding risk premiums to be an attractive means of earning positive real returns while real yields on government bonds are being repressed by central bank policies.
Opportunity in Equities
To many, the understanding that starting bond yields predict subsequent bond returns is intuitive and unsurprising. Perhaps less well understood is that the same relationship between yield and return exists in equity markets. Starting yield, which we define as the ratio of 10-year trailing real earnings per share divided by current price, has been demonstrated to provide an accurate forecast of future 10-year real returns in equity markets.
The correlation between starting earnings yields and subsequent 10-year equity returns is quite high: 70% in the U.S. market, 81% in the United Kingdom, 71% in Germany, and 77% in Japan. Figure 5 illustrates the strong predictive power of starting earnings yields for these four equity markets.
Today’s wide dispersion in equity yields across global markets provides tremendous opportunity for investors willing to look beyond the seemingly safe U.S. equity market with its high prices and low yields. Other equity markets around the world are priced much lower and consequently provide higher yields and correspondingly higher expected returns. We forecast a