The Bond Market is the GOAT of Financial Markets

This weekend I bumped into a friend of mine who is a portfolio manager for a $150M mutual fund and we got to talking about the state of the world economy and the recent volatility.

In a nutshell, his view is that the US is likely to join other developed nations in offering negative interest rates and that this may lead to some bad scenarios for the US and world. However, it’s unclear how it will play out or when this may happen since we’ve never seen negative interest rates before.



What’s happening with interest rates?

Interest rates have been falling across the world and there are now about $15 Trillion dollars worth of negative-yielding bonds world wide. This represents about 30% of the government debt market and 15% of the total bond market.

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Negative Interest Rate Bonds

Source: Bloomberg

Japan led the charge into negative territory and it has been followed by Germany and other EU countries. A lender in Denmark recently introduced a negative 0.5% interest rate mortgage (before fees) – so borrowers will essentially be paid to borrow money.

Surprisingly despite all the quantitative easing that has led to negative interest rates, inflation has remained low in most categories and we may even be seeing some deflation.

These low rates have been great for borrowers including countries, companies and mortgage holders since the cost of servicing debt has dropped. On the flip side, low and negative interest rates have been bad for pensions and retirees who are trying to generate enough income from their assets to meet their liabilities through lower volatility bonds.  These groups need to buy riskier assets and embrace that they will need to accept more volatility in order to achieve their goals.

The bottom line is that no one really knows how this will end up since we’ve never seen it before. We may be in a liquidity trap where central banks try to keep economic expansion going through lowering rates, but once rates get close to zero or negative then investors move to cash and the central banks lose control over the ability to set the rate of interest. This creates uncertainty, which decreases economic activity and growth which ultimately negatively impacts the stock market.

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JP Morgan EU Negative Yields

Why are we seeing negative interest rates?

Rates or yields on bonds (or debt obligations) move inversely to the price of bonds, so rates are falling because more investors are buying bonds driving up their prices and lowering yields.

So why are they buying bonds?  Likely for two main reasons. First, there is a lot of excess liquidity out there due to quantitative easing and second because they have uncertainty about future growth and are looking for safety.

So why have we had quantitative easing?   In an effort to help shore up the financial system and boost the global economic expansion countries around the world have been engaged in increasing the amount of money in circulation by purchasing mortgage-backed securities and Treasuries or other government debt.  This also has the added benefit of weakening their currency which makes the country’s products and services less expensive on the worldwide market.

Fundamentally there is a lot more money chasing returns and most of it has gone back into financial assets like bonds (leading to lower rates), equities (leading to higher stock market prices) and hard assets like real estate and commodities.  The benefit of these increasing asset prices has flowed to people with capital vs. labor which has increased the wealth inequality gap.

Where might this lead?

No one really knows since we haven’t seen this before, but in general, my sense from researching this is that most people think it could get bumpy.  Here are three potential scenarios:

  1. Good – we figure it out by dialing up productivity through technology and efficient use of resources and elegantly unwind the massive liabilities while interest rates remain low.  We get back to a more balanced economy that is not propped up by significant government intervention.
  2. Medium – we muddle through and we live in a low-interest-rate environment for a long time with lower growth and low inflation, but no crash or social unrest.
  3. Bad – wealth inequality leads to populism, increasing polarization in society and potentially some kind of social revolution.  Alternatively, we could see a significant bust in asset prices as investors change their view on risk and/or we could see massive inflation which hurts investors and creditors and helps debtors.

How can you hedge yourself?

The same ideas that have helped you get to where you are in life still apply:

  1. Get educated, think critically and stay involved in your community.  Democracy is a team and participation sport.
  2. Maintain a high savings rate – this seems like such a simple idea, but it implies that you live efficiently and make prudent decisions with your resources.
  3. Invest and diversify widely – the only certainty is change and since no one can predict the winners or losers your best bet is to own everything – stocks, bonds, large-cap, small-cap, domestic, international, mortgage, gold, cash, currencies.
  4. Accept that the days of set it and forget it are likely over -  I’m not encouraging active trading, but do think that people will need to pay attention to what’s happening in the world and be willing to make adjustments to their plan.   I’m biased in this area but think that almost everyone can do better by getting organized and defining their retirement financial plan for different scenarios.

Overall I remain bullish that we’ll work through the current negative rate environment, but we’re seeing more volatility and I’d expect that trend to continue in the near future.

This article was written by Stephen Chen from Forbes and was legally licensed by AdvisorStream through the NewsCred publisher network.

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Karmen Lai
Fortis Lux Financial
Fortis Lux Financial
Office : 212-578-0300