• Eugen Neagu

Going negative

The Federal Reserve (FED) has avoided in previous recessions to have negative interest rates. But this seems now to change. On 26 March 2020, the one-month T-Bill was trading at -0.15% interest rates. However, at the last auction the FED sold the one-month T-Bill at 0% rate, allowing buyers from the primary market to sell them on secondary market at a negative interest rate and pocket a profit.

It is expected that T-Bills will be auctioned at negative interest rates soon, to try to increase the steepness of the short end of the yield curve. This is what happened before in Europe and Japan, so I suspect it will happen in the U.S. too.

The FED wants to see the credit flow, but it is ‘limited by our ability to take losses’ (Powel, 26/03/2020) on the collateral that the FED buys. At this moment, the FED could only buy investment grade bonds and diversified ETFs of a selected junk (high yields) bonds, named ‘fallen angels’ – corporate bonds that used to have an investment grade rating, but were re-rated to junk in the last 2 months. Because of that, the only way to ‘make credit flow in the economy’ is to make saving costly for private investors i.e. to drive private investors to take the risk of losses and to invest in the riskier assets like junk bonds and equities.

The last thing the FED would want is to throw sand in the gears of the banking system, by forcing yield seeking investors to buy longer duration bonds and flatten even more the yield curve. In their usual business, banks make the ‘carry’ from lending long and borrowing short term. A steep yield curve is good for bank profits, so how do you steepen a yield curve when short rates are already at zero? By going negative, of course! It will also dissuade the banks to keep money at the Central Bank, as with negative rates, they will pay an interest rate for their deposits with the Central Bank.

There is another effect, as the European Central Bank (ECB), the Bank of Japan (BoJ), and the rest of the word keeps going deeper into negative territory, if the U.S. keeps the interest rate above zero, all else being equal, it strengthens the dollar. So negative interest rates in the U.S. have the potential of turning the tide in favour of foreign assets which offer a higher yield. As a result, emerging markets, especially emerging market bonds and currencies begin to regain some of the ground they lost in the last decade, so the U.S. dollar becomes the funding currency for carry trades around the word.

Last, and perhaps I am treading on rather thin ice here, negative rates are the simplest way to transfer wealth from savers to borrowers, from ‘the have’ to ‘the have-nots’, in a mechanism that could be named as ‘stealth socialism’. For the citizens of highly indebted nations, taking money from the haves and giving it to the have-nots, would count as reducing the wealth inequality.

If the FED can go negative, which most likely they will have to do, what should the investors do? As all financial/wealth planners know, retired investors would need to hold at least 5 years’ worth of expenditure in low duration high quality bonds, ideally US Treasuries, UK Gilts, German bunds, and also hedge the currency exposure. Unfortunately, due to risk ability and risk aversion constraints many investors hold a lot more of their investable assets in cash and bonds, and they will have now to accept lower interest rates than before, most likely negative rates soon. As a result of the lower bond returns, they would have to reduce their retirement planned spending, to make sure their money lasts their entire life.

One simple action the investors could do now is to position their bond portfolio in short duration US Treasuries, UK Gilts, and highly rated investment grade bonds (supranationals, and high quality issuers like Apple, Microsoft, Google, or Amazon) where they can still earn a 0.2% - 0.3% per annum yield. As yields would become negative, they will make gains on these bonds.

The more important option left to investors is to discuss again with their financial/wealth planner the possibility of increasing their allocation to equities. With the yields so low or negative, investors should take the opportunity to increase their equity allocation and allocate to what is named (or known) as ‘bond proxies’. Getting in early at these lower valuations would be an advantage.

In the recent past, these companies have been derided as overvalued, but the doubters have been wrong so far, and these companies performed very, very well in the last decade, and held very well in the last couple of months of pandemic too. Due to their high quality, these companies manage to tick over nicely, and their net earnings keep coming at 4% - 5% per annum/share and growing. The pandemic did not affect them much, in fact for some companies this pandemic offered a tailwind, because some companies are in the healthcare sector, and some others in the consumer staples sector, benefiting from an increase in demand for cleaning products as people behaviour will remain ‘germ adverse’ for a long period of time.

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Note: Capital is at risk when investing and you could get back less than you put in.