Last month’s note discussed the power of the Federal Reserve Bank to influence the economy and markets. In short, central bankers set the price for the most important commodity, money. The fed funds or risk-free rate of interest influences most economic decisions and the valuation of all assets. Since 2009, the federal funds rate has ranged between .06% and 2.42%. With the cost of money low, and a hunger for higher returns, investors have elevated the price of every asset known to man (stocks, corporate bonds, real estate, art, cryptocurrencies, leveraged loans, private equity, etc.) Truly a “wonderland”.
Wonderland? We shall see. Alice in Wonderland, a novel by Lewis Carroll, was written in 1865. Its sequel, Through the Looking-Glass, was published six years later. It features the same Alice climbing through a mirror (looking glass) and into a world where everything is reversed, just like the reflection in a mirror. Clocks run backwards, playing cards and chessmen come alive, flowers talk, that sort of thing. Well, what does all this have to do with investments, you might ask?
Consider the following. Around the world, there currently exists around $12,500,000,000,000.00* (that’s trillion) in bonds priced to yield less than zero. In other words, negative yields. The creditor pays the borrower. Buyers of these bonds receive a guaranteed negative return if held to maturity. Current examples for 10-year sovereign bonds with negative yields-to-maturity are as follows:
Germany - .33% Switzerland - .54% Japan - .15%
Equally astounding, there presently exists a ‘century bond’ issued by the Republic of Austria, yield to maturity .…... 1.17%. This bond will mature in ….….. (drumroll) .…….. 2117. If interest rates ever head back up, all of the above-mentioned bonds will become hot potatoes which will burn quite a few fingers.
With U.S. 10-year treasury notes currently yielding around 2.00%, we are not yet ‘through the looking glass’. But Germany, Switzerland, and Japan clearly are. The European Central Bank and the Bank of Japan have spent years employing monetary policies that, while stimulative in theory, have clearly not produced the desired growth or higher inflation.
As for the U.S., at what point does investor sentiment change? After all, money has been cheap for ten years. Will even lower rates be enthusiastically received, or instead raise concerns about future growth in the economy and corporate earnings? Are we at the point where the central bank wizards have lost their magic powers? Will we too pass through the looking glass?
Stay tuned. Happy July. Don’t forget to fly your flag on the 4th!
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*Financial Times / Opinion - The Long View / June 24, 2019
Any opinions are those of James Aldendifer and not necessarily those of RJFS or Raymond James. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. Investing involves risk and you may incur a profit or loss regardless of strategy selected. The above situation is a hypothetical example for illustration purpose only and does not represent an actual investment. Bond prices and yields are subject to change based upon market conditions and availability. If bonds are sold prior to maturity, you may receive more or less than your initial investment. Holding bonds to term allows redemption at par value. There is an inverse relationship between interest rate movements and bond prices. Generally, when interest rates rise, bond prices fall and when interest rates fall, bond prices generally rise.
U.S. government bonds and Treasury notes are guaranteed by the U.S. government and, if held to maturity, offer a fixed rate of return and guaranteed principal value. U.S. government bonds are issued and guaranteed as to the timely payment of principal and interest by the federal government. Treasury notes are certificates reflecting intermediate-term (2 - 10 years) obligations of the U.S. government.
