Take a look at the $100 bill, ¥10,000 note, and €100 note. They are all pieces of paper with an intrinsic value near zero. Their money-like characteristics establish the value for each bill or note. With roughly the same monetary value, give or take a fluctuating amount in foreign exchange markets, they can each buy a good meal in Tokyo, New York, or Paris.
Things become a little more complicated when a currency is used outside of its normal jurisdiction. A cashier at a US supermarket may be confused if a shopper pays with a ¥10,000 note instead of a $100 bill. But there are some establishments that do accept foreign currencies. They may be found in countries that do not trust their currency in circulation. A prime example today is Venezuela, with its hyperinflation, destructive government, scarce goods for sale, and rush for food – all while President Nicolás Maduro uses the army to suppress his hungry population. The euro, yen, and US dollar have terrific value in Venezuela.
The characteristics of cash include the value of its purchasing power. “Store of value” is one of money’s prime attributes.
Another attribute is its function as a unit of account – a way to measure. Compare a $10 bill with a $100 bill. What is the difference? There is a different face engraved on the front of the $100 bill and one more zero printed on the piece of paper. In America, the difference is simply accepted. Each person in the world who uses money makes an acceptance decision every day. Some of us are lucky enough to have choices. Most folks do not.
The third money characteristic — its function as a medium of exchange – depends on where you are. We just wrote about that and how acceptable money is in the US. If you have a hyperinflation – like in Zimbabwe, or in Germany in the early 1930s during the Weimer Republic, or currently in places like Venezuela – money no longer works well as a medium of exchange. Nobody wants cash because it is losing value at a very rapid rate.
Take the same characteristics and turn them around. With little inflation in the price level and mostly stable prices, the “medium of exchange” function becomes very reliable.
How do negative interest rates influence the use and the characteristics of money?
At Cumberland Advisors, we think of this question in the following way. If there is a choice in the Eurozone to hold cash or use a negative-rate deposit, the user may be able to compute the cost for the latter. That cost of a negative-rate deposit alters the uses and characteristics of cash because it adds a defensive measure to the calculation.
Essentially, a negative interest rate means that a banking facility or institution will charge someone for the privilege of storing their cash. Now there are options and new decisions to be made. One may take the risk of holding €1000 in cash in a safe and hope that no one steals it. Or one may take that €1000 and deposit it somewhere for a fee. At the end of the year, at a 0.4% negative rate, that €1000 becomes €996. Essentially, one year of storage costs €4 on an excess cash savings deposit of a €1000.
At the margin, such a transaction alters behavior. It changes how people visualize cash. In Europe, we are now seeing at least one major insurance company convert deposits to cash and hold the physical cash under an armed-guard safekeeping system. We are also seeing people prepaying taxes and expenses in Europe. Why should anyone hold cash and pay taxes tomorrow? They have to be paid at some point. Paying those taxes now removes the cost of storing the cash in a banking facility. It actually transfers that cost from the individual to the governmental unit receiving the payment.
In Japan the fear of negative interest rates has created a demand for ¥10,000 notes. Households are assembling some of their wealth in notes and storing them. The reason is simple. They do not want to pay a storage fee to some government institution or banking facility. They also expect negative interest rates to spread in Japan just as they have spread elsewhere in the world. And a zero inflation experience for 20 years has enhanced the store of value attribute of holding physical cash.
Let’s compare two instruments. One option is physical cash. It can be held, spent, or safely stored for another day. Physical cash does not lose its buying power due to storage costs. It does risk inflation, or loss of buying power in the future. Or it can gain buying power if deflation occurs.
The other option is to buy a debt instrument denominated in the same currency. If someone buys a debt instrument in the German government bond auction, the interest rate is negative. That instrument becomes an electronic-entry security denominated in euros and issued as a very strong governmental credit. That buyer is no longer holding cash, unless that instrument is sold and turned into cash. The price of that instrument, should it be turned into cash prior to its maturity, is unknown.
Negative-interest-rate securities that will mature many years from now are currently available in some countries. Let's look at them versus cash.
In the case of cash, the government promises to replace one piece of paper with another piece of paper so that cash can be substituted for cash. In the case of the debt instrument, the government promises to pay the amount of cash denominated on that bond or note.
When the interest rate is zero or less than zero, which alternative is more desirable? In our view, it is cash. The risk rises in the negative-interest-rate security. The longer the maturity and the deeper the negative rate, the higher the risk associated with that instrument. That is the trade-off of negative interest rates versus cash.
NIRP proponents argue that central banks using negative rates want to encourage the holders of cash, and banking intermediaries, to do something with it. There is an attempt to change behavior in order to spur economic transactions – and therefore economic growth. A secondary effect of stimulating growth would be to raise the rate of inflation or remove deflation. Japan has attempted to do so since the early ’90s and is now resorting to negative rates among its many and varied stimulative policies. See the news reports today on the latest BOJ meeting.
In today’s crazy world, there are 24 countries and 6 currencies – one quarter of the planet’s output – where negative interest rates are part of governmental policy. Another quarter of the planet’s output is housed in the United States, where the US dollar carries a very small positive interest rate. The fourth of the world in negative interest rates is putting downward pressure on the positive rates in the US.
There is now a trade-off at work in American bond markets. Bond yields, in Cumberland’s view, are lower than they would otherwise be were it not for the downward pressure of negative interest rates from elsewhere.
The remaining half of the world is stimulating its monetary policy, attempting to lower positive interest rates, and creating more expansive credit conditions. That is where we find ourselves today.
Along comes Brexit. The shock from Brexit throws the markets into turmoil and essentially gaps down the levels of interest rates to where they have been since the beginning of July. The gap down from June to July is significant. Bond rates are now at levels where valuation techniques suggest that risk in bond prices is rising dramatically. This is a change from the earlier part of 2016.
We do not know where long-term interest rates will go or what the downward pressure on rates from NIRP will be. Although we expect NIRP to broaden because too many players are too committed to the policy and may need to let it run its course, we do not know how much NIRP there will be. We currently have approximately $12 trillion equivalent in debt-related instruments trading with a negative interest rate. That balance is rising at the rate of $200 billion to $300 billion per month worldwide.
If NIRP is spreading, why is Cumberland Advisors now worried about the future of the bond market? Why is Cumberland now gradually redeploying assets more defensively in the bond market? The reason is rate-of-change analysis. Here is an attempt to discuss it in a very simple way.
A substantial price change was introduced when negative-interest-rate paper went from $0 to $1 trillion. The impact was nearly doubled when it expanded from $1 trillion to $2 trillion. And it was still powerful as it moved from $2 to $4 trillion.
We are now at $12 trillion, and we may get to $15 trillion. Each increment of negative interest rate policy is altering behaviors. But does the increment of another $1 trillion equivalent in negative-interest-rate paper have the same impact as the first $1 trillion did?
We think the answer is no. We think the use of NIRP has now broadened enough that its impact on the dollar-denominated bond market is understood and is measurable in credit spreads and other technical ways.
That leads us to the following conclusion. Will US policy making revert back to a greater consideration of influences such as economic growth, inflation, banking system needs, liquidity needs, and the needs for reserves and compliance with global Basel III standards? We think US monetary policy is going to focus more on these elements. We think that process will unfold in the second half of 2016 and into 2017. We think the influences from Brexit and NIRP will be waning on US policy.
We also observe that nearly all measures of inflation in the United States seem to have bottomed and are turning up, albeit at a gradual pace. We believe many of those inflation measures will be close to or even exceed the Federal Reserve’s 2% target by the end of 2016.
What happens to central bank policy in the United States when there seems to be solid evidence that inflation has topped 2%? What happens to interest rates in the bond market when market agents begin to say that the Fed now can normalize the term structure?
We expect the Fed to hike interest rates one quarter point before December 31, 2016. The Fed will proceed at a very slow pace because it does not want to derail the continued gradual economic recovery in the United States. The Fed knows a 2% inflation rate is an acceptable level. It has advertised that for years. The Fed would have to see inflation rates trending towards 3% before it begins to accelerate and intensify the normalization of monetary policy. There is no way to know when the trend will move toward 3%.
What we do know is that bond market interest rates are not currently reflecting this pricing. The bond market is not using normal valuations. The 10-year Treasury yield, in our opinion, would be above 2% were it not for the influence of NIRP. Instead, it is approximately 1.5%. We estimate that approximately a half a point in the benchmark 10-year US Treasury yield has been influenced away by activities taking place in one quarter of the world’s economic jurisdictions (the NIRP world).
Our conclusion is that bond risk is rising. At Cumberland Advisors we are repositioning portfolios gradually in both taxable and tax-free bond accounts. We do that by altering the composition of the bonds to have more defensive characteristics and by shortening duration. This allows calls to occur. It also allows the use of instruments and techniques, including a barbell approach, in portfolio design. Please remember that Cumberland manages only separate accounts and therefore tailors the account structure to the needs and requirements of each client.
In our US stock market portfolios, we have made a major sectoral change. We have exited the utilities sector. We have been in this sector for years. We liked the utilities sector because it has all of the interest-rate sensitivities that can be seen in the stock market. This sector has now reached extreme levels by traditional valuation metrics. It is trading at a decade-high price-earnings ratio and at a multi-decade-high price-sales ratios. The utilities sector has reached a point at which the yield on its dividends is the only compelling factor. It has been a marvelous, outperforming overweight sector for investors.
As the Brexit shock arrived, utility stock outlook prices went up. The higher levels suggest that most of the good news for utilities is priced in, while the risk side is developing faster than the benefit side is. Following Brexit and the utility rally, we exited what was the largest overweight sector position in our US ETF portfolios.
Now a final note on timing. There is no way to know the timing of interest-rate changes. We continue to estimate forces that would alter rates and map scenarios that can change the application of those forces. All of that is speculative since no one can predict with certainty what the future will bring. The future has components of risk, and some of those components lack clarity.
Cumberland Advisors is adapting its US bond and US stock portfolios to the changes underway in the new, post-Brexit-gap world. We are repositioning accounts to more defensive structures. We have a well-developed rationale behind this risk-management process that we perform for our clients.
Most important for everyone to consider is that we are guessing about future outcomes because we have never been in a climate where one quarter of global output is influenced by NIRP, resulting in a strongly growing desire for cash. The cash statistics show that growth rates in the US, Eurozone, Japanese, Swiss, and other currencies are outpacing the actual growth rates of those economies.
We now have about 1.4 trillion US dollars in circulation throughout the world. That number is growing at an annual rate of approximately 7%. The Fed continues to engage in a monetary policy that will provide the world with all the cash it demands. The Fed has done so since the end of World War II. If Fed policy is flat year after year, as it is currently, then in terms of balance sheet size the Fed is altering the composition of its liabilities as cash demand expands. At the same time, it is indirectly creating pressures on security assets like Treasury notes, bills, bonds, and mortgage-backed securities, because the demand for cash comes first.
Thus, the transfer of $100 billion into cash demanded by the world means a shift away from the application of the Fed’s balance sheet to provide other things or to support positions in the securities market. The rate of change of this process is accelerating, and the forces driving that acceleration are vast and not well understood.
This makes the task of our central bank enormously complicated as it supplies the US dollar reserve currency to the world. We could make the argument that the Fed’s balance sheet should be $3.5 trillion instead of $4.5 trillion. We could equally readily make the argument that the Fed’s balance sheet today should be approximately $6 trillion. We don’t know which is correct, and we don't know the future rate of change. But we do know the demand for cash is rising, and it may continue to do so at a robust and accelerating rate.