8.23.2019 Weekly Update: "Smile You Son of a..."

Weekly Recap                                                                        

S&P 500                -1.7%

10 Year Treasury   +0.14%

Gold                      +0.96%

Volatility              +10.55%

Weekly Update: “Smile You Son of a…..”

“You’re gonna need a bigger boat.”  The iconic line from the movie “Jaws” is often quoted in many financial blogs and columns describing a situation in which there was a complete underestimation of the risk at hand.  A case in point would be the meeting that took place at the New York Federal Reserve building the Sunday of the “Lehman Brothers” weekend.  I’m sure Hank Paulson and Timothy Geitner, as the banks described the contagion effect posed by AIG Insurance, thought to themselves, “We’re definitely gonna need a bigger boat.” 

But I’m not going to write one of those papers.  Instead, I want to talk about “Jaws 4:  The Revenge.”  In case you are not a connoisseur of the killer shark genre, “Jaws 4” is mercifully the end of the “Jaws” movies, and the one where the mother of the original killer shark actually follows the remaining members of the Brody family down to the Bahamas to exact revenge for the death of her offspring.  This movie came to mind as I came across an article about a report by a Societe General analyst, Albert Edwards. The report, from 1995, detailed a scenario in which one day all government bonds in the world would trade with a negative yield.  To say that his prediction was early is a bit of an understatement.  In actuality his prediction pre-dated the first negative interest rate bond by about 30 years.  In his report he used the analogy of the Ice Age to depict a scenario where negative rates slowly creep across the globe.  Edwards believes that negative rates in one country have a contagion effect which leads to negative rates in other countries, as investors chase relatively higher rates around the globe until all rates become negative. 

I’ve highlighted in a couple recent newsletters, the virtually ridiculous scenarios which this has caused; such as negative junk bond yields in Europe and negative mortgage rates in Denmark.  Now, this week, Germany has issued a 30 year bond with a negative interest rate.  Essentially, the German government has borrowed 824 million euros, it pays no interest, and only is obligated to repay 795 million euros in 2050.  Sounds like a good deal, at least for the borrower.  Therefore, if we follow Edwards analysis, it appears only a matter of time before we begin to see negative rates infiltrate the U.S. 

To show how this plays out let’s imagine that you are an investor looking for a safe haven investment to store your money.  You’ve watched the Netflix show “Narcos,” and saw that Pablo Escobar lost millions of dollars burying his money underground because rats simply ate it; so you want someplace safe from rats and the cost of negative rates.  You look across the ocean and see that the United States is offering a 2% coupon on a 30 year bond.  You assess the stability of the US dollar as being strong, so you, and your friends, begin gobbling up U.S. Treasury bonds.  As more and more demand for the bonds is created the price of the bonds pushes higher, causing the yield on the bond to fall.  The demand for the coveted Treasury bonds continues until the rate becomes comparable to the rates throughout Europe.  On it goes until every government bond yield in the world, so long as it is not Argentina, begins to fall closer and closer to zero and beyond.  But it doesn’t stop there.  Rates on corporate bonds like Apple and Google begin to trade at negative yields.  Who knows, maybe even JCPenney, if it is still in existence, can borrow money for nothing.  Get the point?  Like the ice from the Artic, rates are creeping slowly down, and they may not stop until the entire surface is covered. 

Which brings me back to “Jaws 4,” and the law of diminishing returns.  Like a run of bad sequels that seem to announce the end of a successful movie franchise, lower interest rates have a diminishing rate of return for economic benefit.  Rate cuts have a greater impact when they are cut from 5% to 2.5% than they do from 2.5% to 0% or 0% to -2.5%, once you get to a certain interest rate level people actually begin saving more rather than spending more.  This is precisely what is taking place in Europe.  Lower rates lead to lower expected returns for all investment classes, which in turn forces people to save more in order to reach their future goals.  The “Jaws” franchise had truly run its course when it went 3D in #3, but it wasn’t really over until it went all the way down with #4.  Here’s hoping we get some intercession before our economy hits “Jaws 4.”

Thanks for reading,

Zach and Dave

Calibrate Wealth
515-371-5316  

https://www.calibratewm.com/blog-01

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