Negative interest rates could be the permanent norm rather than a temporary historical aberration, a new CFA Institute Research Foundation paper argues, with profound consequences for markets and societies.
In a 116-page CFA-published ‘monograph’, founder of hedge fund LongTail Alpha, Vineer Bhansali, says the “grand monetary– fiscal experiment” of negative interest rates put in place post the global financial crisis appear entrenched in many places.
About 20 per cent of the total global bond market currently trades at negative yields, Bhansali says, in a phenomenon at least five years old in some regions (and much longer in Japan).
He says there is a “distinct possibility exists that negative rates and negative bond yields could become the normal state of affairs in the coming decades”.
“Could we look back with nostalgia at the days when bonds used to provide return from interest?” the study says.
“… It is entirely possible that we are actually witnessing the natural consequence of humanity coming to a stage of its development where interest on deposits will take the same walk down memory lane that the Walkman cassette player did a few decades ago.
“That we are at the end of multiple centuries of financial market dominance is just conceivable, and negative yields are an intermediate mechanism to reset the system.”
Alternatively, Bhansali says if the negative rate experiment is “the biggest distortion of the past half century in financial markets as our gut, which might be wrong, tells us, then the eventual unwinding of the distortion will be painful for many and profitable for some”.
“As with the dot-com bubble and bust or the housing bubble and bust, if negative rates and yields have created asset price bubbles in stocks and bonds, then the consequences to the financial markets and the economy will be substantial if this status quo changes,” he says in the paper.
In a wide-ranging study, Bhansali delves into the potential consequences and implications of the negative yield universe for monetary policy, asset valuation, diversification, risk management, banking, investment and digital currencies.
He says from a technical perspective, negative-yielding bonds operate like an option with an “asymmetric payoff if the yields become more negative”.
Negative-yielding bonds might provide “insurance against catastrophic deflation, default, or geopolitical troubles”, the paper says, although there may be better risk-management solutions.
But Bhansali warns any “disorderly unwind of many of these policies, whether due to political or market reasons, can be substantially disruptive”.
“The lesson for market participants is straightforward: Those who are looking to global bond markets for long-term positive returns at current levels of risk and reward, or even diversification, are likely to be disappointed if and when government backstop for these markets is removed (which, of course, is not predictable),” he says.
“… From the perspective of risk premium harvesters, the conclusion is even more straightforward: Perhaps for the first time in recent memory, a long-term investor may earn a risk premium not by buying bonds but by doing the exact opposite because a bond sold at a premium price today will pull down to par at maturity!”
Titled ‘The incredible upside-down fixed-income market’, the report features an introduction from Bill Gross, ex PIMCO chief – and former colleague of Bhansali.
“Bond markets are possibly at a critical potential inflection point that will result in investors having to think of the ramifications of the current negative yields and the path of return to the more normal positive-yield environment sometime in the future,” Gross says.