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Causeway Capital Commentary - Negative Interest Rates: A Primer for Equity Investors

Negative interest rates upend familiar financial relationships, yet they have become pervasive across several developed global markets. Danish banks are paying homebuyers to take out mortgages. Nearly Germany's entire yield curve was below 0% in early September. Even in the US, the term premium, which represents the additional compensation that investors require to hold longer-term debt, turned negative this year. As of the end of August 2019, the buyer of a 10-Year Treasury bond pays a premium to hold that bond relative to the alternative of rolling over a 1-Year Treasury Bill for ten years.


What could compel institutional savers to accept losing money on their bank deposits, and bondholders to pay to loan money? How can an equity investor benefit from the likely consequences of this sustained ultra-loose monetary policy?

We begin our primer by examining the magnitude of negative yielding debt.

How much negative yielding debt exists currently?


Since December 2018, the amount of debt carrying negative interest rates has increased significantly.

Most of this debt is issued in Europe and Japan.

The stock of negative yielding debt has more than doubled, from approximately $8 trillion at the end of 2018 to approximately $17 trillion at the end of August 2019. That means that investors are paying, rather than receiving, interest to hold over a quarter of the global debt market. Negative yielding debt is not limited only to sovereigns--it increasingly includes corporate and mortgage debt as well.


Why are interest rates currently negative?


The sudden drop in the term premium in 2019 and the increase in the stock of negative yielding debt is, we believe, due to a supply and demand imbalance. The demand for safe haven assets, particularly from institutional investors like pension funds, with few other options for low-risk assets, has outstripped supply. European financial institutions must own these bonds, even if negative yielding, to satisfy central bank-imposed liquidity regulations. Some investors have directed capital flows to safe haven assets in

response to rising geopolitical risk and expectations for a slowdown in the global economy. Demand for negative interest rate bonds likely also reflects investor expectations of additional sizable monetary stimulus from the European Central Bank ("ECB") and Bank of Japan ("BOJ"). With this support in place, investors expect to sell the bond at an even higher price/lower yield. Excess savings in the aging developed economies has likely arisen for several reasons, including demographics, the shift to less capital-intensive, more service-oriented economies, and the significantly reduced level of investment following two decades of massive Chinese industrialization.


Not only has demand risen, but also a supply shortage has occurred globally. By massively expanding their balance sheets, central banks have effectively removed large amounts of sovereign, mortgage and corporate bond supply from the market. For example, the BOJ is buying the lion's share of Japanese government bonds ("JGBs"), and it also owns approximately 77% of Japan's overall exchange -traded fund market. That does not leave much for anyone else, exacerbating the supply shortage of JGBs.


What might spur a rise in rates?


A resolution to geopolitical risks, including the US-China trade war, Brexit, and Hong Kong protests, could propel the term premium into positive territory. Furthermore, any significant and sustained rise in inflation expectations would likely push up interest rates. With low/no cost of financing, governments may decide to use fiscal policy more aggressively, especially if they believe that monetary policy options are exhausted. In a negative rate environment in which some governments are paid to borrow, costless funds can fuel fiscal expansion. According to Modern Monetary Theory, a sovereign can expand its central bank balance sheet and engage in fiscal stimulus until inflation becomes a problem. Central banks remit any interest earned to their country's treasury, and perpetually roll over principal, obviating the need to repay debt.

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This article first appeared on GuruFocus.