Okay. It’s true. We’ve become slightly obsessed with negative yields at FT Alphaville. Especially with regards to what they signify for the financial industry.
Though, for a long time we’ve felt very much alone with this obsession. Weirdly enough, nobody else has seemed too bothered about it. (Note, we even had to go to the ECB directly to ask Draghi what he thought about it.)
Indeed, much of the industry still seems to think negative yields may be transitional.
We, however, are not so sure about that. In fact, we don’t understand why analysts aren’t factoring in deflation scenarios when assessing real interest returns more frequently, since doing so might even show that negative yields aren’t as bad an investment as you think. (In fact we’d love to see under what sort of deflation scenario today’s negative yields might even look like a good investment.)
So with news that Germany just sold €4.173bn of 2-year notes at a negative yield of -0.06 per cent, we’re delighted to finally see some proper analysis about negative yields. It comes from HSBC’s asset allocation team and is entitled “Living with negative yields”.
And they get right to the point: Return of capital is the new return on capital
As they note (our emphasis):
The main issue that has faced us since launching the Allocator back in October 2010 has been the preservation of capital. As it turns out, the market is now willing to pay for the privilege of sleeping tightly at night. This is demonstrated by the fact that a few European bond markets are now trading at negative real yields. At first this may increase consumption under the premise that why save if interest rates are so low (or even negative)? This argument becomes even stronger if there is inflation. However, as the reality of pensions dawn on consumers, low interest rates/expected asset returns should spark a higher savings ratio. This is particularly true given aging populations and the state of fiscal balance sheets.
Which means it really comes down to satisfying the needs of aging populations (though hasn’t it always been?). And as it turns out, even positive yields can’t guarantee that because what really matters are real returns relative to wages.
As HSBC explain:
Let us look at an example. Assume that someone is 40 years of age and has a full year’s salary in savings. The person is expecting to work until the age of 70 and live to 85. Given the relatively poor outlook for wages, let us assume that average real wage growth will be 1% until the point of retirement. At retirement, let us say that one would need 60% of final salary in real terms to maintain an acceptable standard of living. Furthermore, let us assume that the outlook for real expected returns is challenging and in line with exceedingly low/negative yields, say 2%. In this case, the person in question needs to save 31% of their salary until retirement in order to spend the last bit of savings as one gets closer to 85 years of age. That is, leaving no legacy. However, the main input that matters in this calculation is the real investment return that one can expect. As can be seen in chart 1, the required savings rate is highly dependent on investment returns.
Needless to say, few people are able to save anywhere near this level. To flip this question around, what would be the real wage as a percentage of final salary one’s savings can sustain until death given a savings rate of 10%? A not terribly ‘golden age’ pension level of 25% of final salary is what one has to look forward to. Alternatively, one could work longer. Under the same assumptions as above, one would have to work until 76 years of age and only look forward to 9 years of retirement.
And finally a mention of the role that deflation might play in boosting real returns, as well as what this eventually means for banks:
All of these previous assumptions are in real terms so inflation could have an impact on this behaviour. If deflation would get a foothold the real returns would subsequently go up. Then there is the problem that any inflation may be the ‘wrong’ type of inflation; that is, commodity price and import price inflation rather than wage growth. So, for many people, the dawning of the reality that they may be destitute in their pensionable years should, at some point, set in. The alternative option that they face is working much longer. Such a realisation is, however, a quintessential paradox of thrift and is of course hugely negative in terms of consumption in the western world.
Furthermore, the appetite for hard assets, and cash in particular, is likely to rise if negative yields persist. In terms of unintended consequences, the demand for cash could see safety deposit boxes replacing normal bank deposits. In turn, this could actually have a negative impact on banks’ balance sheets. So much for policy support.
It’s interesting that, amidst all that, HSBC focus on the dangers of the wrong sort of inflation and how this threatens to make a large class of pensioners destitute, impacting consumption in the western world.
We can understand their point. But we think they may be underestimating the degree to which government stimulus can help. An economy plagued with deflation and negative yields has much more capacity to issue and soak up its government debt. If that spending power is allocated intelligently and fairly, say to the elderly demographic in the form of non-interest bearing central bank money, not only is that demographic’s destitution avoided, it helps out global consumption.
Our point really is that the destitution in the eye of the beholder. In a negative yield universe we may actually all be wealthier than we think. It’s just that wealth is harder to access, at least for as long as government spending is constrained.
The negative carry universe – FT Alphaville
On the transfer of risk and the mystery of low yields – FT Alphaville
The ‘high-powered money’ problem – FT Alphaville