- Investors are wise to be concerned by zero and negative interest rate policies promulgated by central bankers, because starting yields predict future investment returns. Zero real interest rates predict zero real returns, and negative real interest rates predict negative real returns.
- For long-term investors, risk is more about failing to meet wealth accumulation goals than about short-term changes in the price of their portfolios; thus, the more appropriate measure of risk is the estimated probability of reaching or failing to reach the desired or needed long-term real return level.
- Given the new NIRP environment, investors may wish to look beyond a traditional 60/40 portfolio to a portfolio holding substantial allocations in non-U.S. equities, alternatives, and credit.
Negative interest rate policy, or NIRP, is the most recently deployed weapon of central bankers in their long campaign of financial repression—a deliberate policy of depressing interest rates in order to transfer wealth from savers (private citizens) to debtors (largely governments). Financial repression is intended to improve near-term growth by encouraging consumption and discouraging savings. Why save today if your money will purchase less tomorrow?
Whether NIRP will produce the results intended and/or create unintended problems is not the subject of this article. Rather, we discuss how investors may wish to alter their investment plans to take account of the changes in expected returns both within and across capital markets given the new NIRP environment.
Abandoning ZIRP for NIRP
Many investors are understandably unnerved by news of NIRP. In Europe and Japan, monetary authorities have concluded that zero interest rate policy (ZIRP) has been insufficient to meet their inflation targets. Consequently, the European Central Bank and Bank of Japan replaced ZIRP with NIRP in June 2014 and February 2016, respectively.1 Government bonds issued by these governments, and some corporate bonds in these markets, now trade at negative yields. The Fed has not (yet) deployed NIRP but is actively discussing it. In a Congressional hearing on February 11, 2016, Federal Reserve Chair Janet Yellen said the Fed is “taking a look at them [negative interest rates]…I wouldn’t take those off the table.”2 In addition to the eurozone and Japan, the central banks of Denmark, Sweden, and Switzerland have also adopted a negative interest rate policy.
In years past, economists generally dismissed negative nominal interest rates as a mere theoretical concept. In the real world, went their reasoning, rates were bounded at zero because savers would store cash in a vault before they would endure a negative interest rate. As the Swiss National Bank demonstrated in December 2014 when the institution lowered its deposit rate to −0.25%, the cost of storing cash is the actual lower bound for nominal interest rates. Nominal interest rates, we now learn, can fall to −1.00% or more before savers will abandon their bank accounts for physical cash.
Ten-year real return forecasts3 are a valuable input to long-term investment planning! For investors who establish and stick to long-term plans and are able to persist with those plans over multi-year periods—for those with the conviction to increase positions that have disappointed over recent years—read on. Traders beware. Long-term return forecasts can be worse than useless for those looking for a trade. Over periods of months (and even a year or two), such forecasts are not much better than random noise. Frequent trading on such signals will enrich your broker, not you.
Negative Rates and Returns
Real interest rates (nominal interest rates minus the inflation rate) determine the growth in real purchasing power from investing in bonds. Real cash rates have been negative across the developed world since the global financial crisis in 2008. Today, real bond yields are negative in longer maturities too: out to 5 years in the United States, past 10 years in the United Kingdom and the eurozone, and across the entire yield curve in Japan, as shown in Figure 1.