Negative interest rates are rational, according to one top bond specialist, despite investor fears over the dramatic fall in bond yields and the rise of negative yielding debt.

“Negative rates seem irrational but it really all comes down to supply and demand,” said Robert Tipp, managing director and chief investment strategist at PGIM at Investment Magazine’s Fixed Income and Credit Forum held in Victoria’s Yarra Valley.

While the surge of negative yielding bonds – which have risen to US$16 trillion – may to some extent reflect the rising risk of a deflationary global recession, Tipp said more important is the shift in the balance in the supply and demand for money. “The markets are dominated by the demand of savers and investors much more than borrowers,” he said.

The PGIM strategist has long argued that the equilibrium level of rates is continuing to shift to lower and lower ranges as a result of a swing in secular factors – aging demographics, high levels of indebtedness, rising inequality and aggressive unconventional monetary policy by the European Central Bank and the Bank of Japan.

“The global economic environment appears softer than expected and the equilibrium level of rates correspondingly lower than we thought. Otherwise, wouldn’t the lower level of rates have already stimulated growth and stabilized or boosted inflation?”

But at the Forum, he went a step further and underlined the importance of aging demographics as well as the secular deceleration in manufacturing.

“If you have new product innovations, urbanisation, great investment opportunities and a young demographic which is prepared to borrow from the future – in order to get money now – long term interest rates are pushed up,” he told delegates. “But right now, we have the opposite. The young demographic that needs more housing and the inventions that require a lot of immediate capital for investment –that’s over,” he said.

Tipp said the driving force in the market is no longer a need to borrow, but instead a surplus of money as people actively save and money piles up. “They no longer want to borrow from the future – the driving force in the market now is the need to save for the future. And that is pushing long-term bond prices up and yields down.”

Importantly, he went on to say, because there is so much cash sloshing around in the system, not only do investors not earn a rate of interest on that money, they have to pay to store their money.

“This is true in absolute terms in places with negative rates like Japan and Europe, but virtually across the developed markets in real terms where short term rates are barely matching inflation.”

While he conceded that the central banks, in the cases of Japan and Europe have initiated and tipped the balance, nonetheless the bulk of the move has probably been caused by natural market forces.

Asked how low rates could go, Tipp said he thought Australian, US and European rates look like they’ve fallen toward relatively neutral levels at this point.

The strategist predicts medium to long-term rates are likely to fluctuate around central tendencies of 1 per cent for Australia, 1.5 per cent in the US and below zero for German bunds and Japanese government bonds for the foreseeable future. However, with negative momentum stalking the global economy and the US dollar continuing to rise, he concedes negative rates in the US cannot be ruled out.

As he sees it, market volatility is likely to remain “intermittently high” but insists that will provide opportunities. He also believes that bonds will outperform cash — albeit with much higher levels of volatility.

“There is a lot of pessimism that yields are low or they’re negative and therefore it is a bad investment environment and it is true that if, going in, your yield is lower, your long-term expected return will be lower. But there are still positive yield curves in many of these countries with negative rates which means you get a higher yield as you go further out on the yield curve, and a higher return if rates ultimately stay low,” he said.

“The higher volatility means you still have a wide opportunity set for adding value through active management. You have opportunities to increase or decrease duration, rotate among global rates markets, and sectors, and take advantage of the opportunities created by the fact t people are very disorientated by this rapidly evolving environment.”

Although the pace of the global expansion is slow — and likely to become even more so given ongoing trade tensions— he thinks the expansion is nonetheless likely to continue.

As a result, Tipp added, a range of so-called spread product — in particular high-quality structured product, select investment grade and high yield corporates, European peripherals and emerging market debt — are likely to outperform over the intermediate to long term as the low yield backdrop fuels the search for yield.

During his presentation, the PGIM head was asked why rates suddenly lurched lower so rapidly. He pointed out the general trend to lower rates had been going on for decades – albeit peppered with shorter term fluctuations.

“The drop has continued accelerating with recent trade tensions, but an additional contributing element is the 180-degree change in tone from the worlds’ central banks,” he added.

Tipp reminded conference-goers that in the middle of 2018, it looked like the next move by the world’s central banks would be to lift rates. Even the Bank of Japan widened the acceptable trading range on 10-year government bonds which signalled their intention to allow yields to go higher. “It looked as though central banks could be normalising rates, but now they have totally reversed. Not only are they not raising rates, they are widely expected to cut, and the ECB to resume asset purchases.”

He further warned that over time, it may become clear that central banks pushing rates more and more deeply into negative territory may just serve as an effective tax on savers and investors, and only further dampen the economic outlook, exacerbating the risk of a vicious cycle of rates being even lower for longer.

 

Elizabeth Fry has been a financial journalist for more than 25 years and has written for a number of publications, including CFO, The Financial Times and The Australian Financial Review.
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