I am sure you have all heard about negative interest rates in Europe and that some $12 trillion worth of bonds have a negative yield. These are predominantly in Europe and Japan. To make matters worse more than 20% of European investment-grade corporate debt has negative yields and this week was the first corporate issuance of a negative-yielding bond. I pay to lend you money.
Who would buy such a bond?
The answer lies in one word – relative. This bond is the best alternative to a range of other worse alternatives. So why invest at -100bp when I can invest at -25bp, that’s a better deal. I introduced this relative concept when discussing the Australian dollar and why it had to continue declining in recent years, months and into the future. The relative yield differential between Australia and the US is in record negative territory. Don’t think that matters? Look at the correlation below (Aud$ in red). Anyone who tells you that commodity prices influences the Australian dollar trend doesn’t know what they are talking about.
I am totally in the camp that there is a debt crisis coming, because negative yields is madness. No economic textbook in history talks of negative interest rates. A day of reckoning will come. It’s a bit like a rotting tree, you know its going to collapse and hurt someone. You can see it weltering, you can see the cracks but while its still producing fruit, people are going to hang around the tree enjoying those fruits. That’s what we have now. But what are those fruits?
That’s the assets producing positive yields across the world and what we end up with is a yield crunch. Since last year I have been discussing this yield crunch thematic and with each new central banker speaking it only cements that thematic. The ECB and RBA both said they are ready to step in with more liquidity if the economy shows additional signs of weakness.
So as more and more bonds – Government, corporate and junk – have negative rates, the appeal of other assets producing positive yields becomes more and more attractive. And its not just low risk infrastructure and property assets that investors flock to, but anything that has sustainable and reliable earnings.
As more and more bond yields continue to head to zero and below around the world, the more it will drag every other yield as well. Inevitably the attractiveness of infrastructure stocks must mean that they yield levels closer to zero too. I mean aside from debt ranking ahead of equity, why would anyone pay a negative rate on a corporate bond when you can buy Transurban or Sydney Airports or Australian Pipeline Trust on yields of 3-4%+? These have to be yielding 2% or below. On a relative basis they are just too attractive.
Money will slowly continue to move further and further out the risk curve. Ever watch the nature shows where the lakes dry up and the animals begin to migrate to wherever they can find water, even its muddy and there is risk of being eaten by lions or crocodiles, otherwise they will die of thirst? Well that’s exactly what is and will continue to happen in financial markets.
This brings me to my next point. Think about a pension fund. They have an enormous responsibility to pay out these annuities for the next 100+ years and they need to be able to balance their returns with the outgoings of those payments. If bonds and traditional safe-haven assets or negative or zero what do you do? They have mandates that prohibit riskier equity style investments so what do they do? They begin to buy assets. What assets? Infrastructure.
Don’t be surprised if we begin to see a bidding frenzy begin for some of these assets. Rumors have circulated in the past, I expect there to actually be action in the future.
So as the investors looking for yield migrate through the financial markets, the underlying value of these assets will be pushed to strati strophic heights. As central banks try to reflate economies after rates are at zero is to print money. I cannot see how in any future circumstances hard assets of real constant value like gold do not skyrocket. The day of reckoning will come global when this madness will need to be re-adjusted. However, the merry-go-round still has many more spins to go before the music stops. Riding the thematic of the yield crunch and precious metals, is still the safest bet.