Toto, I have a feeling we’re not in Kansas anymoreDorothy in Wizard of Oz
With a negative yielding investment, the price you pay exceeds the sum that you will get back at maturity plus the income you receive in the interim. If you buy a negative yielding bond you are guaranteed to lose money. If the rate you receive on bank deposits is negative, you are guaranteed to lose money.
Negative interest rates are becoming kind of a big deal:
Most negative yielding debt is government debt, which is ironically considered “safe”, at least in first world countries. With government debt, you know what cash flows you will receive during the holding period, and what face value amount of principal you will receive upon maturity. With everything else, cash flow is uncertain and principal is always at risk. Indeed the yield on government debt functions as a proxy for the “risk free rate” , which is a critical input in financial models investors use to make strategic decisions throughout financial markets.
Conservative investors generally prefer to hold a lot of government debt in order to meet future needs. Pensions, banks, and insurance companies are required to hold a minimum percentage of their assets in government debt so they can safely meet obligations to their stakeholders.
Negative interest rates cause a lot of surprising second order impacts throughout the world impacting how people do business.
The Black Scholes model is one of the pillars of modern finance. It uses the risk free rate as an input but it cannot compute when the risk free rate is negative. It requires users to calculate a logarithm. Yet the logarithm of a negative number is undefined/meaningless. Here is a paper that explored the implications in more detail. Maybe people can use the old Brownian motion models, but there isn’t going to be universal agreement right away on what to use.
Any switchover will create unintended consequences throughout the investment world . Lots of funds hold over the counter options or swaps which must be valued using models in the time between their initiation and expiration or exercise. This valuation impacts the number that appears on the statement of investors. To the extent that investors have asset allocation targets around what percent of the entity’s assets can be invested in what, this will have secondary impacts in other markets. A lot of large firms have to totally change their valuation policies which is never easy to do because valuation departments are plenty busy with their jobs as it is. Markets aren’t going to close just so they can rewrite their valuation policies.
Also, in cases where a swap or OTC option contract requires collateral to be posted as the pricing changes throughout the life of a contract, both sides of the contract need to agree on valuation methods. When interest rates are positive, Black Scholes is a noncontroversial options I doubt contractual language was written in a way that accommodate for a world where Black Scholes would completely stop working.
Currently, more banks are trading a wide number of options without a reliable price. Each bank could handle this problem by performing its own solution, but the lack of a shared approach could lead to serious legal issues.Source
This stuff is all theoretical but it has real cash impact throughout the world. What types of risks can be hedged will impact how capital can be allocated. How capital is allocated directly impacts what ideas get funded.
Now lets consider the real world impact on different groups of investors.
In theory, negative rates should stimulate the economy. If investors only invest in safe assets, nothing else will get funded. Retirees need income from investments to live, foundations need to earn enough to safely withdraw funds, etc etc. If the bank charges them to hold their cash, they will invest more in real estate, high yield debt, and venture capital etc. They will have to take no more risk because “there is no alternative”(TINA).
However, when you look at how negative rates will impact pensions, banks and insurance companies, its hard to escape the conclusion that they might have a destructive, rather than stimulative impact on financial markets.
People live longer than they can work. To prevent a social catastrophe, countries have different ways of providing for old people. Pensions are a big part of the financial markets According to CFA society: Willis Towers Watson’s 2017 Global Pension Assets Study covers 22 major pension markets, which total USD 36.4 trillion in pension assets and account for 62.0% of the GDP of these economies.
In the US people pay into Social Security, which provides a bare minimum standard of living to old people. The Social Security Fund is only allowed to invest in US Treasury Securities. If Treasuries yielded negative, the Social Security Fund will erode over time, meaning it won’t be able to meet its bare minimum obligations to retirees.
Social Security by itself barely provides enough to live on. A lot of people in the US and around the world also have pensions through their jobs as well. The impacts of negative rates get more nuanced and even weirder when you consider how these work.
First of all, extremely low interest rates worsen pension deficits. Future obligations must be discounted backwards. Lower discount rate leads to higher obligations in the present day. On the other side of their balance sheet, they must make an actuarial assumption about future returns on their investments. From what I’ve seen they often make aggressive return assumptions. To try to justify higher return assumptions, they put what they can into riskier investments. To this extent pension funds are partially in the TINA Crowd.
Pensions are generally also obligated to put a certain amount of assets into “safe assets” which are the first thing to start yielding a negative rate. As a result, this negative rate will create a destructive feedback loop.
Gavekal had this story of a Dutch Pension as an example:
One day he was called by a pension regulator at the central bank and reminded of a rule that says funds should not hold too much cash because it’s risky; they should instead buy more long-dated bonds. His retort was that most eurozone long bonds had negative yields and so he was sure to lose money. “It doesn’t matter,” came the regulator’s reply: “A rule is a rule, and you must apply it.”
Thus, to “reduce” risk the manager had to buy assets that were 100% sure to lose the pensioners money.
Pension funds get caught in a feedback loop that will erode their capital base. For example say they buy a 5 year zero coupon bond at €103:
The €3 loss will reduce the market value of assets by €3. Holland also has a rule that pension funds must buy more government bonds the closer they get to being underfunded. Yet buying such negative-yielding bonds and keeping them to maturity ensures losses, making it more likely the fund will be underfunded, and so forced to buy more loss-making bonds (spot the feedback loop). Soon the fund will be distributing returns from capital, rather than returns on capital. Hence,it is not inflation that will destroy pension funds, but the mix of negative rates and rules that stop managers from deploying capital as they see fit. These protect governments, not pensioners who are forced to buy bad paper.
So negative rates will exacerbate the global retirement crisis. Oops.
What about banks? Negative rates also destroy their capital base, and leave them with less money to actually lend out in the economy. This hits at the heart of how fractional reserve banking works.
According to Jim Bianco at Bloomberg:
For every dollar that goes into a bank, some set amount (usually about 10%) must go into a reserve account to be overseen by the central bank. The rest is either lent out or used to buy securities.
In other words, the fractional reserve banking system is leveraged to interest rates. This works when rates are positive. Loans are made and securities bought because they will generate income for the bank. In a negative rate environment, the bank must pay to hold loans and securities. In other words, banks would be punished for providing credit, which is the lifeblood of an economy.
Gavekal explains how this leads to an eroding capital base (using the same 5 year zero coupon bond as the pension example above):
As a leveraged player, let’s assume it lends a fairly standard 12 times its capital. This capital has to be invested in “riskless” assets that are always liquid. In the old days, this would have been gold or central bank paper exchangeable into gold. Today, the government bond market plays the role of “riskless” (you have to laugh) asset, which has no reserve requirement. As a result, banks are loaded up with bonds issued by the local state. Now let us assume that a bank has just lost €3 on the zerocoupon bond mentioned above. The bank’s capital base will be reduced by €3. Based on the 12x banking multiplier, the bank will have to reduce its loans by a whopping €36 to keep its leverage ratio at 12. Hence, the effect of managing negative rates while also respecting bank capital adequacy rules means that the capital base can only shrink.
One of the main ways that insurance companies make money is by collecting premiums in advance of paying out any claims. Hey are able to invest these premiums, collecting a float premium. Of course they are limited in how much risk they can take with the money they are holding to pay out any possible claims. Regulators generally require them to put a certain amount in a “risk free “ asset like government debt, and the rest in riskier assets. If government debt is negative yielding, we again get to a destructive feedback loop that has major second order impacts.
From the Gavekal note:
The insurance company could raise its premium by the amount of the expected loss from holding the bond (not very commercial), or it could just underwrite less business. Either way, it will have less money to invest in equities and real estate. Simply put, either the insurance company’s clients will pay the negative rates, or the company itself will do so by increasing its risks without raising returns. This means that either the client pays more for insurance, and so becomes less profitable, or the insurance company takes a hit to its bottom line.
People will have to pay more premiums for less insurance coverage.
Long term, negative rates will exacerbate the retirement crisis and basically destroy the business models of banks and insurance companies as we know them. This doesn’t automatically mean negative interest rates can’t persist. Perhaps there are other ways to provide for old people (ie higher taxes on a shrinking economy?) Banks and insurance companies can find other ways to make money. Regulators might respond, by changing rules or creating various incentive programs.
In this post I only covered only a few of the second order impacts of negative interest rates. Negative interest rates make the capital asset pricing model give nonsensical infinite results. I think CAPM is mostly bullshit anyways, but enough people use it that it has a reflexive impact on asset pricing. Unwinding it won’t be easy. I didn’t even touch on how negative rates can screw up the plumbing of financial markets: repo markets, securities settlement , escrow etc. Not enough people have really thought this all through. Many of the assumptions that have historically driven investor behavior will no longer hold if negative rates persist.
Maybe interest rates will normalize again. It will wipe out a few of the most overleveraged players, but the financial system will recover quickly. On the other hand, if negative rate do persist, get ready for a slew of unintended consequences in places you didn’t expect.
Mysterious by Howard Marks at Oaktree
Humans have flawed brains that cause them to act crazy sometimes. And in groups, people get even more crazy. Many smart people believe dumb things. Sometimes a group of otherwise completely sane people come together and do something insane. History is full of examples of the “ Extraordinary Popular Delusions and the Madness of Crowds, or Manias, Panics and Financial crisis. Humans sometimes join suicide cults. Human literally burned witches not that long ago. Groupthink is a helluva drug.
Financial markets provide an arena in which the biggest gains can be made betting against consensus. Yet statistically speaking, the consensus is usually right. The times when the crowd goes crazy are notable because they are exceptions. One must carefully decide when to be a contrarian.
Under what conditions is the consensus likely to be wrong? Lets invert the question: under what conditions is the crowd likely to be right?
Most of the time, a large group of people actually comes to a more accurate conclusion than any one individual. The success of Estimize, which crowdsources earnings estimates is one useful empirical example. “Wisdom of Crowds” is a well documented phenomenon, and well summarized in the book by the same title.
Why is the crowd so often right? What must happen for the crowd to be right ? Researchers have identified four interrelated conditions that encourage the wisdom of the crowds:Diversity, Information Availability, Decentralization, and existence of an Aggregation Mechanism.
Understanding these conditions can help one know when to follow the zeitgeist, and when to make a contrarian bet against it. A firm grasp of the facts on both sides of a controversy is necessary, but possibly not sufficient. One can never be sure of all the facts. Its also useful to understand the broader social forces, and how they influence the likelihood of the consensus being right or wrong. Searching for these conditions(or their absence), can be a useful method of avoiding cults and identifying opportunity, beyond just the facts of the individual situations.
The biggest gains are available by being a contrarian who understands the crowd.
The key is understanding when the wisdom of crowds flips to the madness of crowds. And the essential insight is that it has to do with a violation of one or more of the core conditions for a wise crowd.Michael Mauboussin: Who is on the other side?
Diversity implies that each person has their own point of view and some private information, even if only their unique interpretation of the available public information. Diversity is important because it adds different perspectives and increases the amount of available information.The Value of Crowdsourcing: Evidence from Earnings Forecasts
Crowded trades have a tendency to crash- leading to no bid markets all the way down. Academics have noted that in a run up to a market crash diversity of population declines. The market becomes fragile, and eventually there is no one to buy from (or sell to).
One reason Estimize’ earnings estimates have tended to be better than Wall Street Sell side is that Estimize analysts are a diverse group of independent thinkers from around the world, holding a variety of different jobs. A lot of Wall Street analysts go to the same conferences, went to the same schools, etc.
When people come to the same conclusion from different backgrounds, logical methods, etc , their collective wisdom refines understanding of reality. The opposite occurs when people feel pressure to conform. Its important to note this is a genuine deep diversity of thought and perspective, not a superficial check the box diversity.
If multiple people with different viewpoints all come to similar conclusions, the odds of the opposite being true decrease substantially. On the other hand, if there is an obivous archetype of the thinker on the other side, then maybe a contrarian opportunity is available.
As Michael Maubossin has noted- conformity is a nonlinear process:
Scientists even have a sense of the neurobiological basis for conformity.Informational cascades occur when individuals follow the decisions of those who precede them without regard to their personal information.
Epidemiological models are useful here.
The wisdom of crowds does not emerge in groups of idiots. It only applies when there is widespread access to information necessary to reach a conclusion. The extreme opposite occurs in totalitarian societies (or large corporations), where information is tightly restricted. Prior to the internet, information sometimes diffused slowly through a market, leading to massive price discrepancies obvious at even a quick quantitative glance.
Quality of input is critical to the success of crowdsource analysis:
Alternatively, it is possible that the inclusion of forecasts from certain individuals, such as Non-Professionals, may provide no value, or worse, cause the Estimize consensus to deviate further from actuals. Surowiecki (2004) states that although diversity matters, assembling a group of diverse but thoroughly uninformed people is not likely to lead to wise outcomes.
Independence is related to diversity. People need to be able to freely analyze reality and discuss opinions. Conventional wisdom is more likely to be accurate when it is freely subjected to challenge. When there are institutional or social factors that make people extremely afraid to speak truth, what everybody says to be true, may be wrong.
Independence requires relative freedom from opinions and actions of others, not complete isolation. Independence enables people to actually express their diverse information and reduces potential bias in the group decision.
Decentralization allows people to specialize and draw on local knowledge, without any individual or small group dictating the process.
Diversity and independence all fit in nicely with decentralization. Through specialization, decentralization encourages independence and increases the scope and diversity of information. Decentralization reduces the risk that independence and diversity will go away. Similarly having capital flows from all around the world, not just from a small group of schools or similarly thinking firms, increases the likelihood that markets become more efficient.
Existence of an Aggregation Mechanism
Finally, an aggregation mechanism is necessary to collect the individual opinions and harness the ‘wisdom-of-crowds’ effect.
This is basically why capitalism has succeeded. The price mechanism aggregates facts about supply and demand better than any bureaucracy could. At the same time, this why often the best opportunities to earn an investment profit are in illiquid asset classes where the market does not function as an aggregation mechanism to make the price close to right.
Of course, just because the market consensus is wrong, doesn’t mean that is necessarily wise to bet against it today. Must also consider reflexivity, narratives, and capital flows etc, and maintain a balance sheet that allows one to survive long periods of mass delusion.
Postscript: This is all indirectly related earlier post on finding underfollowed opportunities: The hard thing about finding easy things . This linked the ideas of both Sun Tzu and Warren Buffett. Some of the specific opportunity sets mentioned in this post have since been too widely known and we’ve moved further into more esoteric off the beaten path ideas. Nonetheless the basic principal still holds: there are more likely to be opportunities where the crowd isn’t looking.