Welcome to Finance and Fury –
This Episode – Look at Where to not invest in negative rates world – if it comes to that – other options
First – what does the world in negative rates look like?
– dive further into this to start – look at other countries, Japan, Denmark and how this affects an economy –
- Also – what sort of investments won’t fare well – run through alternative assets
- Going to be 2 parts – go further into alternatives next week
What asset classes may be at risk – financial sector
Negative interest rates are terrible for banks – They destroy the business model for banks.
- Put further pressures on banks margin (profits) – make future bank collapses more likely because banks cannot build capital to absorb losses
- Commercial banks act as streams in the modern economy – Glacier (Central Bank) melts and the money flows through commercial banks and financial systems
- No ice – no flow – but no rivers – water nowhere to go – a dam that breaks and floods everything
- European banks are looking to be in poor shape – have negative yields but getting the exact opposite of what they need – Growth from stimulus spending and inflation
- Japan – same thing – used QE strategy to lower rates back before the term QE was muttered – originals – how well did it work long term?
- Japan has had near-zero or below zero interest rates for 20 years – stuck in liquidity trap
- How well has financial sector performed – 1980s – in Japan’s bubble years
- TOPIX Banks Index – Peak 1989 at 1,500 – now it is about 130 – loss of 91% over 30 years
- If this spreads to the rest of the worlds financial sector – financial sector suffers – by extension – the economy suffers as low-risk decisions are required – lower business lending
- Banks make money from the difference between the interest rates they charge on loans and costs on deposits (liability as a reserve to lend out) – you get interest due to risk – also issue FI –
- Rates go negative = ability to make a profit gets thinner – but risks get larger on the assets loans collateralised against – i.e. property for mortgages
- Remember – pieces of the assets used as collateral have been inflated by these low-interest rates –
- Seen that play out with Japan back in the late 80s
- Denmark currently – 3rd largest bank offering 10-year mortgage rates at -0.5% – 20year fixed at 0% –
- borrowers will make repayment as usual – but the amount still outstanding will be reduced each month by the negative interest
- but savers see nothing paid in interest on their deposits – and may also suffer as they go negative
- Switzerland – UBS a few weeks ago sent a memo to HNW clients -introduce 0.6% p.a. charge on deposits more than €500,000 –
- Bank of England at 0.75%, ECB at 0%, Denmark (not ECB based) -0.4% cash rates
- Lower savings rates across Europe – Commercial banks need to take deposits and extend loans. That’s their primary function. This credit intermediation, as it’s called, is like a financial utility. One bank can be allowed to fail. But the banking system overall cannot be allowed to fail – why capital notes are being used as ‘reserve capital’ – replace lower deposits
- How banking meant to work – profit motive needs to make them aggressive on lending, and the fear of loss needs to make them prudent.
- Those two forces are supposed to balance each other out over time, with banks swinging too far in one direction and then too far in the other direction as part of the normal business cycle.
- Generally worked through history – when back with gold or other currencies – some hiccups, as long as banks can do this profitably – meaning they make enough money and set aside enough capital during good times to be able to eat the losses during bad times without collapsing.
- This sort of event created Central Banks – lender of last resort to provide liquidity – today – manage insolvency as fiat is debt-based
- Negative interest rates make banks start losing money on their assets – need to chase yield to make some kind of profit
- Have to do risky investments – sometimes will come with inadequate returns or compound systems risks
- ECB, the BoJ, and Swiss National Bank have admitted that negative interest rates weaken banks – not speculating here – The ECB has even been talking about a strategy to “mitigate” the destructive effects its policies have on the bank – cash bans
- The real economy – negative interest rates have an even more profoundly destructive impact: They distort or eliminate the single-most-important factor in economic decision making – the pricing of risk.
- Bit of a guess – Similarly, portfolio management tools like Capital Asset Pricing Model (CAPM), Modern Portfolio Theory (MPT), Value At Risk (VAR), Risk Parity are all ill-equipped to handle a world of lasting negative interest rates
- Risk is priced via the cost of capital. If capital is invested in a risky enterprise, investors demand a larger return to compensate them for the risk. And the cost of capital for the risky company is higher. If capital is invested in a low-risk activity, the return for the investor and the cost of capital for the company should both be lower. And the market decides how that pans out.
- But if central banks push interest rates below zero, this essential function of an economy doesn’t function anymore. Now risk cannot be priced anymore. The perfect example of this: Certain junk bonds in Europe are now trading with a negative yield. This shows that the risk-pricing system in Europe is kaput.
- World where risks cannot be priced correctly anymore – consequences – probably going to be bad over the longer term for the real economy – creates misallocation – malinvestment and bad decision making
- Means overproduction and overcapacity – asset bubbles of where borrowings flow
- Load the entire financial system up with huge risks because these assets are used as collateral, and their value has been inflated by negative yields.
- The observable outcome from these policies – strange combinations – massive housing bubbles in cities while slowing economy – Germany – Berlin and Munich while they look to be about in a recession –
- Or Aus – Syd, Melb – Not much wage growth, slowing GDP growth – misallocation of lending – bubble in consumption (demand side) without supply (businesses/overall economy, wages, etc.) catching up
- Monetary Policy remedy to this situation caused in part by negative interest rates – more of the same thing
- Longer negative interest rates continue – more upside down and unpredictable our economic system will become
- Harder for us to reverse course – without financial system throwing their hands up, bailing and starting afresh – Nothing new
- And a major reset is of course precisely what every central bank fears the most – How will this end?
- No one knows because this size of a reset has never occurred before – some idea: When there is no reward for saving and bonus to borrow – the economy stops functioning properly – slow decline before being abandoned
- What this all shows – that the financial system is pretty sick – the cost of its money is so low –
- Financial reset is likely needed –Few options the IMF have been publishing about – with SDRs, or Crypto backed by gold or SDRs
- Over the next few years – may see a dollar-denominated asset collapse due to the USD going through replacement speculation
- A lot of the Debt in the global financial system is back by USD – so if you can collapse the value – you collapse the size of the debt owed
- If rates continue to go down – if they go Negative in Aus would be bad for ASX index investments – 25% in Financials – mostly big 4 banks – crash to index from a handful of shares triggers wider panics and sell offs
- Passive investments (indexes) along with the FAANG shares – may not fare so well
- A lot of factors look to be pointing towards systemic risks –
- Passive/Index ETFs – liquidity risks – not selling underlying shares but selling the ETF – need a buyer – May be hard to find in a panic –
Few different alternatives next week –
- Inverse ETFs (BBOZ and BBUS) – various assets and derivatives, like options, used to create profits when the underlying index declines in value. Basically, it’s an index ETF that gains value when its correlating index falls
- Versus – the “old money” strategy – about capital preservation – gold, land or art ETF
- Both have pros and cons –
Thanks for listening, if you want to get in contact, you can do so here.