Economic and Market Review - May 2016: The Problem Of Negative Interest Rates

by Gavin Graham, Chief Strategy Officer May 27, 2016 (Revised May 27, 2016)
Notice: This newsletter is intended as a general financial market outlook, and should not be relied on as investment advice.
The attempts by central banks around the world to help the global economy recover from the Financial Crisis of 2008-09 and prevent the onset of deflation (falling prices) have led to several paradoxical outcomes. The first of these is obvious to anyone who is attempting to earn a decent return on their savings. With short term interest rates at 60 year lows, having fallen to 0.5% in Canada and 0.37% in the US, it is almost impossible for an investor to make a real return on their money after inflation.

While former Bank of Canada Governor Mark Carney, now Governor of the Bank of England, did increase Canadian short term rates from 0.25% to 1% in 2010, his successor Steven Poloz reduced them twice in 2015 to offset the negative effect the downturn in oil and commodity prices was causing the Canadian economy.

In the US, new Federal Reserve Chairperson Janet Yellen did remove the U$80 billion a month of stimulus that the Fed was providing at the end of 2014 throughout last year, and finally raised the Federal Funds rate by 0.25% in December. However, this was seven years after the recession caused by the Financial Crisis ended, with unemployment at a 10 year low of 5%, and with US GDP growing at more than 2.5%. Furthermore, having indicated in December that the Fed was ready to raise short-term rates as many as four times this year, the language now emanating from the central bank has shown that worries over the slowdown in China, the world’s second-largest economy, has led the governors to pull back from being so aggressive. Now interest rates may rise only twice before the end of the year, or there could even be only a single rise.

The situation is more serious in the Euro-zone and in Japan, where both the European Central Bank (ECB) and the Bank of Japan (BoJ) are now using negative interest rates in an attempt to get banks lending to the real economy again. In other words, the ECB and BoJ are charging banks between 0.15-0.35% p.a. on the balances that commercial banks hold with them, and it was regarded as a major surprise when the BoJ did not move interest rates further to the negative at its regular policy meeting in the last week of April. This caused the Japanese yen, which had already strengthened from Y121=U$1 against the U$ in February to Y111=U$1 to plummet 5% to Y106=U$1 in the first week of May. This is apparently illogical; the currency whose interest rates are falling is strengthening against the currency whose rates have risen. The fact that the yen has strengthened over 10% against the dollar so far this year indicates that most investors do not believe that US interest rates will go up much further.

Similarly the ECB has also further lowered its negative interest rates this year, but the Euro has reacted logically by weakening somewhat, down 5% year-to-date. However, most observers believe this weakness in the Euro has more to do with the ongoing problems with deficit countries in the Euro-zone such as Greece and Portugal and the impending UK referendum on an exit from the EU (known as Brexit) than the ECB’s actions. It seems that monetary policy has been pushed as far as possible in providing stimulus, and making short term rates even more negative will not be enough to weaken the currency and make it more competitive.

The second paradoxical outcome is the effect negative longer term interest rates have on the world of savings and pensions. According to some estimates, almost one third of the U$5 trillion global government bond markets now has a negative yield. Anyone buying German Bunds as far out the yield curve as 5 years will lose money when the bond matures, as 2 year Bunds have a negative -0.5% p.a. yield and 5 year Bunds -0.32% p.a. At least 10 year German Bunds have a positive yield, although it is a minuscule 0.22% p.a. but in Japan 10 year JGBs have a negative -0.13% yield. In Switzerland, the ultimate safe haven, the 10 year bond yields a negative -0.32%!

While bond yields are still positive in North America, with the 10 year Canada yielding 1.46% p.a. and the 10 year US Treasury 1.79%, both of these yields have fallen (by 0.25% and 0.34% respectively) over the last year. All of this makes the job of the individual investor or pension fund trustee almost impossible. The assumptions that were used when pension funds were established assumed that they would earn around 6-8% p.a. returns before inflation. This was relatively easy when short term interest rates were 3-5% and longer term bond yields 5-8%, as was the case as recently as a decade ago.

Assuming that the fund’s assets were invested in the classic allocation of 60% equities/40% cash & bonds, then the math was straightforward.

40% bonds yielding 5%=2% 60% equities returning 6.5%=4%

Now the numbers don’t add up. With investment grade bonds including those issued by companies yielding less than 2%, then the return from the fixed income side of the portfolio is now only 40% x 2%=0.8%. This means that the equity portion of the fund has to produce 9% returns to meet the required target. 60% x 9%=5.4%. Of course, these returns are before fees and trading costs, so the problem is even bigger.

Of course, this is the case in North America and the UK, where long term bonds still provide a positive yield. In the Euro-zone and Japan, where government bonds are not only very low, but actually negative, the return from the fixed income portion is effectively zero. For companies liable for the returns from Defined Benefit (DB) plans, every drop in the long-term bond yield makes their liability larger, and many companies are now having to make large payments into their pension funds to keep them solvent. In effect, they are being run for the benefit of the pension fund rather than the shareholders.

This is why companies have been switching to Defined Contribution (DC) plans where the investment risk is borne by the retiree, not by the company. While DC company pension plans still offer many attractive features, such as 50% or 100% matching by the company for every dollar invested by the employee, and the assets in the plan grow tax free until the employee reaches retirement age, this is nothing like the guarantee of a percentage of your final salary that DB plans provide. Of course, those in the best position of all are government employees, who not only have the taxpayer standing behind their DB plan, but in many cases can retire after 25 or 30 years with an inflation-linked government pension and then work in another job until they decide to retire.

For individuals who are self-employed, including many professionals such as lawyers, doctors and accountants or entrepreneurs and franchise owners, there is no possibility of an employer match for their pension contributions and obviously, no DB scheme. The Registered Retirement Savings Plan (RRSP) and Tax Free Savings Account (TFSA) allow tax sheltering of investments and, in the case of the TFSA, tax free withdrawals, as the contributions were made from after tax dollars. However the amounts that can be sheltered are limited and the type of investments that can be used are limited to those generally available to retail investors. Individual Pension Plans such as the INTEGRIS Personal Pension Plan (PPP), designed for this group of self employed professionals, accountants, entrepreneurs and franchise owners would be a more effective and flexible retirement solution for this group”.

To return to the title of this piece, the problem of negative interest rates means that conventional fixed income investments can no longer be relied on to comprise the 40% of a pension plan that they traditionally provided. With alternative income-producing investments that, like bonds, are not correlated with the stock market, such as private equity, infrastructure, hedge funds and other absolute return focused assets. These investments, many of which have only become available to smaller investors in the recent past, form part of the armoury for large public sector and sophisticated private pension plans. The INTEGRIS Personal Pension Plan (PPP) allows the incorporated individual to gain access to many of these assets, putting them on a level footing with many DB plans as far as investment choice is concerned. If central banks succeed in keeping interest rates at their present low or negative levels, investments providing a reasonable level of income with low volatility will end up substituting for traditional government bonds. Negative interest rates are destroying the traditional pension plan, and investors will need to have access to alternatives if they are to enjoy a secure retirement.

Sources: Bloomberg and Globe and Mail on May 5th 2016