Today the 10 year German bond is yielding less than zero. If you spend 124 Euros to buy a bond you will get 2 Euros every year for the next ten years, and then 100 Euros on maturity. You might be better off burying your 124 Euros in a jam jar in the backyard. Yet there are now about $10 trillion worth of sovereign bonds trading like this. (A trillion is a thousand billion. The annual economic output of Canada is about $2 trillion per year). What’s going on? Why would anyone buy a bond with a negative yield?
A good place to start is with the U.S. Federal Reserve Bank and its policy of “quantitative easing” or QE begun by its Chairman Ben Bernanke in 2008. The theory of QE was simple. The Fed would create new money (that’s what central banks do) and use it to buy already issued bonds in the open market. Like everything else, if the supply of something is fixed and demand increases, the price would go up. In the bond market, a higher price means a lower yield. Lower yields mean lower borrowing costs for consumers and companies. Lower borrowing costs should lead to more economic activity, like home buying and business expansion. Over the course of 6 years the Fed went all-in on this policy, ultimately buying about $3.6 trillion of bonds. The first part of the theory worked fine. Bond yields went down and interest rates in the economy did too. The second part did not work so well. The economy remained sluggish and although employment increased, growth in economic output remained well below long term trends and still shows no signs of accelerating.
Why didn’t QE work as planned? Consumers came out of the recession with big debt loads and high anxiety levels (a big recession will do that). Rather than using the low interest rates to go on a spending binge, they increased their savings, paid down debt and refinanced mortgages and car loans at lower rates. Making things worse, commercial banks did not use low rates to boost lending, but actually tightened lending standards, further constraining growth.
Businesses also failed to behave as hoped. Rather than expanding factories, buying new equipment or opening new locations, they used low rates for non-productive financial engineering. Apple has borrowed $53 billion at low rates to buy back stock. Microsoft just bought LinkedIn for $26 billion, which it will pay with borrowed money. Stock buy-backs and mergers do not create jobs or increase output. They just move money from one pocket to another. The QE program has created an ocean of cash.
While this was going on in the United States, the British and European central banks, faced with even worse economic growth, decided to launch their own QE programs. The results have been much the same.
Eight years after the start of QE there is a huge amount of excess capital sloshing around in the world financial system. Owners of this cash have to do something with it. In a nutshell, here are their choices:
-Buy stocks. But stocks look expensive with the S&P 500 having tripled since its low of March 2009, and with low growth, how will corporate profits rise?
-Buy real assets like real estate, infrastructure and commodities. But these kinds of things can be hard to buy and even harder to sell, and future yields are uncertain.
-Buy bonds. Okay, the yields are terrible but at least they are liquid, the risks are foreseeable and who knows, maybe someone else will buy them at an even higher price.
-Simply hold cash in a bank account. No possible upside, but perhaps a downside.
While market-watchers find it surprising that so many have chosen the bond option, we believe that there is a deep fear motivating much of this bond-buying. It is the risk of deflation and the horrible possibility of ending up like Japan with a stagnant economy, massive government debt, and falling prices. When economies experience deflation, prices for goods and services fall and cash becomes worth more the longer it is held, since by definition, its buying power is increasing. If a holder of cash believes that a Euro will buy more ten years from now than it does today, then it makes sense to buy a bond with a negative yield. After all, what is important is not the nominal return, but the real return. If there is deflation of 2% per year, then a bond with a nominal yield of negative 0.5% has a real return of 1.5% per year. All of a sudden, not such a stupid idea.
For those who lived through the high inflation years of the 1970’s and early 1980’s, the idea of deflation is heretical, almost revolutionary. We are married to the idea that cash becomes worth less over time, and that nominal returns are always higher than real returns, the exact opposite of the case in a deflationary economy. This is why most investors find the idea of negative bond yields so strange.
Our view is that we will not see deflation in the developed economies. We expect to see, instead, gradually rising interest rates and gradually rising wages and prices. In this environment we think stocks will out-perform bonds by a wide margin. We are very comfortable buying high quality companies which pay dividend yields which are often over 3% and which are, even more often, rising year by year. We think a real dollar today is better than a hoped-for more valuable dollar sometime in the future.