Negative in Perpetuity

Over four years ago, I wrote a post, “specter of negative rates is haunting global bond math,” in which I outlined why negative bonds were more feasible than the consensus believed at that time. Back then, I also started to joke about valuations on the perpetually negative yield curve: “What is the value of a zero coupon perpetuity?”

Not so funny anymore. The amount of negatively yielding global debt peaked out temporarily in 2016 and diminished post-Brexit, but now in 2019 stands at new highs and most developed market (“DM”) central banks (“CBs”) are poised to cut rates — even those already with negative rates, such as the ECB and BOJ. The debate on how to implement deeply negative rates and avoid cash hoarding is heating up.

As an intellectual exercise, let’s assume that physical cash is banned or discounted; an increasingly realistic condition. The question then becomes what if the nominal risk-free interest rate curve in the whole DM world is perceived as perpetually negative?

First, it doesn’t mean that all lending has to be at zero or negative rates. To be sure, risky borrowers may still have to pay positive rates.

However, the whole securities market dynamic may shift in a dramatic manner. Imagine when ZERO YIELD becomes the objective of financial engineering.

There is a common perception that zero and negative rates hurt banks in particular. Indeed, European banks, especially Deutsche bank, have been on the ropes as depicted in Figure 1.

Figure 1: Euro STOXX Banks Index (SX7GT)

However, the US banks have weathered several years of zero rates quite well, and the recent acceleration of their performance can be as much attributed to political changes and tax breaks than to the slight rise in the rates. Figure 2, below, depicts the Financial Select Sector SPDR ETF, XLF, over the same period.

I suspect that this difference in performance is structural rather than driven by rate differentials. Should the banks stay creative, who is better to create zero yield instruments? In other words, in the negative rates environment the biggest problem is storage of your cash and assets; therefore, shouldn’t the banks, which are in the business of such storage, benefit?

Figure 2: XLF, Financial Select SPDR ETF

Without diving into an analysis of banks’ balance sheets, let’s shift to the stock market in general. There are many debates out there regarding the impact of interest rates on equity prices. Not being an expert on stock valuations, I will only discuss this at a qualitative level.

There are two commonly observed ways in which lower rates help stocks:

  • Companies pay less to fund operations, or
  • Corporate shares become a more attractive investment relative to bonds

There is an additional approach to looking at the second aspect, which has been recently coming to light.  With negative yields, it is cheaper for investors to borrow money to buy stocks. The primary manifestation of this paradigm is corporate share buybacks.  Indeed, if a corporation can consistently issue debt at a lower rate than its conservatively estimated earnings yield, why wouldn’t it drive its EPS by funding buybacks through debt?

Granted, there are reasons why not, such as the perils of over-leverage, but this is a matter of measure and prudence even if the principle still works.

Another way to look at borrowing to buy stock is speculators buying equity futures. Assuming the margin of 4% on S&P 500 futures contracts, a speculator can synthetically borrow up to 96% to own the index. Current interest rates in the USA are slightly higher than the dividend yield, so the S&P is trading in a very slight contango as seen in Figure 3, below.  That is, you have to pay a slight premium to buy deferred contracts. In other words, if you are holding futures for a long time and the level of the index doesn’t move at all, you are slowly losing money.

Compare this, however, with other markets like the Nikkei in Japan where the synthetic funding rate is negative. The futures are trading in consistent backwardation as can be seen in Figure 4, below.  That is, you are being paid to hold your contracts, not only because of the dividends you collect, but also because of an additional “benefit” of having to borrow. Sure, short-term market swings can dwarf your immediate carry, but over the long run such accumulated benefit can become a powerful force for a speculator.

Taking this thinking to an extreme, an investor may line up to buy shares in any company which has a long-term perspective of non-negative earnings, regardless of how high the valuation is. Theoretically, any perpetually non-losing money concern becomes of infinite value.

There is an important distinction here between money one gives to a corporation in exchange for equity via a primary or secondary offering and money one gives to another investor for a share of this company.

In the environment of negative-perpetuity driving equity demand, will companies keep accepting cash until they are no longer profitable? When their capital is overwhelming, regardless of their original business, they are bound to become asset managers and be stuck with negative yield choices.

Will the incentives continue to point this way? The current shareholders will benefit more from the stock trading higher and higher in the secondary market.

Suppose you IPO a hot dog stand in New York City, which occupies a good corner, and has been netting a steady $10,000 for the last 80 years, paying it out to investors. Without taking any new capital to manage the stand, what kind of multiple of the book value can you get for it?

Practically, in such a world, all corporations will have to be priced with an assumption that at some point in the future they’ll start losing money or liquidate at a loss relative to current valuation. Such perception is very distant yet, as we view our successful corporations not only as indefinitely profitable, but also for having a potential for growth.

This brings us to the conundrum befuddling many market players nowadays: how can the stock market keep making new highs with a real economic cycle that is very likely rolling over (so likely, in fact, that multiple rate cuts are being priced in). How can companies with deeply negative earnings keep rolling out their IPOs?

Now, imagine the global financial system preparing for the onslaught of perpetually negative rates. Any stock with forward-looking positive P/E ratio, no matter how high, becomes a steal. Potentially, the whole market could double from here. Why not 10-tuple or 100-tuple?

Normally, such a bullish perspective on equities would very positive for the economy as the wealth effect would increase spending and investment. But, remember: in the world of perpetual negative rates, there is no such thing as productive investment!

In fact, the more wealth we have in the system the more it has to be invested in losing propositions, potentially spurring contraction rather than growth.

I am not an economist. I am painting this picture as an intellectual exercise as mentioned at the start, rather than putting forward a sound academic theory. Nor am I critiquing the policy, there a lot of pros and cons, and the central bankers’ job is never easy.

However, a weird conception of perpetually stagnant growth and perpetually soaring asset prices has been forming in my mind and appears not to be far from reality.

For the record, I don’t think that this has to be our fate. It is likely the cyclical forces will swing assets lower in the shorter run. Meanwhile, the combination of technological progress and political evolution will lead to resurgence of both inflation and real growth.

The argument I put forward here is designed to understand the secular trend. However, we should be cautioned that arguments of “why the stock market can go up forever” always look most convincing at the top.

Good luck,

Central Banks and Sour Grapes

“Sour Grapes” is my response to all the complaining about central
banks (“CBs”) distorting markets, ruining price discovery, and leading their
countries into the hellscape of negative real rates.

Indeed, if global financial markets were a palace, the floors
would be sparkling clean: the central banks have been using their
counterparties as a mop for almost a decade.

Imagine this….

You are a monopolistic issuer of a product with nearly zero
manufacturing costs, i.e. fiat; and everyone wants to buy this product.

In fact, they are giving you real assets in exchange for it!

Your only worry in this dream-like scenario would be that at some
point the market is oversaturated with your costless product and its value
collapses, i.e. hyperinflation.

However, it doesn’t collapse!

And then it doesn’t collapse some more, and then some more, and
over time you accumulate trillions in real wealth on your balance sheet, which
was funded by the fiat you issued at the interest rate you controlled.


This is not fictional. The Swiss National Bank (“SNB”) has managed
to accumulate a huge fortune in foreign equities by printing Swiss franc, of
which the world doesn’t seem to have enough.


The Bank of Japan (“BOJ”) and the European Central Bank (“ECB”)
have also been voracious buyers of corporate securities.


*Only includes Corporate
Sector Purchase Programme (CSPP) of Asset Purchase Programme (APP).

In the case of the Fed, one can argue that all they are doing is
exchanging the spurious dollar fiat for the equally spurious US Treasury (and
mortgage-backed) paper. Spurious or not, the Treasury has managed to fund the
fiscal expansion and many real-world expenses and projects, both useful and

And then during quantitative easing (“QE”) alleviated the burden
of outstanding debt in several ways: 

  1. For years, the Fed paid just 0.25% on excess reserves and
    was able to fund the bonds and remit the coupon proceeds to the Treasury. Such
    remittances added up to $80-100bln a year (see Fed Remittances below).

  2. QE (arguably) kept the interest rates lower allowing the US
    to pay less interest on the new Treasury issuance. 

  3. QE pushed inflation incrementally higher, (also under dispute,
    but somewhat likely given simple demand/supply considerations) driving the real
    cost of borrowing even lower.  In fact, negative for a long period of

  4. Possibly improved tax collection, as corporate profits were
    aided by the lower interest rates and mortgage interest deductions were
    lowered. At the same time the opposite side of this equation – interest
    collected by savers – may be mostly tax sheltered in retirement accounts. Note:
    A lot of maybes here, as I am not sure of this math.

I am not mentioning any benefits from domestic currency weakness
caused by QE given that with all major developed market central bank’s
simultaneously engaging in QE, this is presumably a zero-sum game.

At this point some readers are probably eager to assert that,
while the central banks have been presented as omnipotent thus far, their
comeuppance is imminent. In fact, many market participants adhere to the belief
that global fiat collapse is now unavoidable and hedge their risk by
stockpiling gold and cryptocurrencies.

In my view, while fiat collapse remains an existential risk to the
global financial system, the current evidence points towards the opposite. We
are not faced with the question of whether the world will absorb the increasing
supply of cash; the world did absorb it. And the central banks, who have
managed to sell it, are now armed to the teeth to defend it.

Indeed, if, as in the case of the USA, cyclical inflation raises
its head and the economy appears in danger of the overheating, central banks
can simply start buying their fiat back. Or, in other words, reduce their
balance sheet – which is exactly what the Fed is doing with quantitative
tightening (“QT”)!

In this process, the assets on the CB balance sheet become exactly
what they are called….ASSETS.

These assets can be and are used to defend the credibility of fiat
by giving it a consistent bid.

Furthermore, if, in cases such as Switzerland or Japan, the
domestic currency was to suddenly spiral down under the weight of increasing
monetary base, the CHF and JPY could be defended by selling foreign assets.

On the flip side, the ownership of domestic sovereign debt by the
CB can be used to mitigate excessive currency strength and a deflationary
spiral as well. The BOJ, ECB, SNB and Fed all have the ultimate stop-gap of
full or partial debt jubilee as described by David Zervos in his “Bondfire of the Vanities” discussion.

Some of you may have noticed, that there is one scenario none of
the above measures would help with…Stagflation.

Personally, I am inclined to believe that stagflation is a
mythical creature, or at least an urban legend.

I know, I know, there are historical examples. (Wait, are there?).

But looking back through my couple of decades in financial
markets, everywhere I turn I see robust growth and moderating secular
inflation. The opposite of stagflation.

Of course, it is possible that the end of both the secular trend
of disinflation and the secular bull market in sovereign debt is here and now.
But I just fail to see the evidence.

Inflation remains moderate, despite a quite prodigious effort to
inflate DM economies. And where, like in the USA, cyclical inflation becomes a
threat, the policy quickly gains traction and flattens the yield curve.

And this is all happening in an environment of a very long
economic expansion. Why should I believe that inflation will become a threat in
a downturn?

Suppose I am wrong. I still struggle to see how the Fed’s large
balance sheet is a problem.

It is a problem if you are forced to sell assets when their prices
are going down. But central banks are never forced to sell, because they
control the funding.

In the hypothetical stagflationary scenario, the CBs will have a
range of possible policy options. They, for example, can
choose to keep rates very a low (even negative) to ameliorate an economic
slowdown and reduce their balance sheet to support domestic currency and
mitigate inflation.

Notice the Fed started to do things in the opposite order (e.g.
hikes first), because stagflation is not a current concern.

All of those arguments are based on the assumption that central
banks are run by intelligent people invested in the long-term prosperity of
their country. Some readers may take an issue with this assumption and if you
feel inclined to have your views swayed by this post, I would also recommend
reading Fed Up: An Insider’s Take on Why the Federal Reserve is
Bad for America
, where Danielle DiMartino
Booth presents a very different perspective.

The question of benevolence of the CB policy ties to an inquiry:
who are the aforementioned hapless counterparties? Are they just reckless hedge
fund managers going short US Treasury bonds or stocks? Or, are they the
domestic savers, including pension funds, who are deprived of yields? Or even
the millennials staring at the absurd housing prices and the absence of ways to
build wealth? Or maybe the 99% watching global monetary flows slip between
their fingers and stream into the vortex of economic singularity?

Preferring to keep the discussion strategic rather than political,
we still have to confront the trope of central banks being run by clueless
academics. Academics tend to be bright and open-minded by virtue of being
academics. Sure they don’t have a good grasp on how the real markets operate.
But neither does everyone else, including economists, strategists, financial
advisors and journalists, politicians, entrepreneurs, and corporate executives.
Anyone without experience as a global macro trader, who must contend with
interconnected financial markets, is comparable to a general who has never
fought in a war.

Yet, some generals trained in peacetime have done well. And those
“clueless academics” pulled off the greatest coup in financial history.

It is my belief that QEs were genuinely intended to, and succeeded
remarkably at, promoting the wealth of their respective nations. Any
disappointment in how this extra wealth ended up being distributed is neither
strictly within the purview of a central bank nor within the scope of this

From a strategic perspective, I am only disappointed the Fed
didn’t cut rates much faster in the end of 2007, didn’t start QE earlier in
2008, and, more importantly, didn’t pursue an even more immense and broader
scale of purchases. Stronger and quicker action may have ameliorated the Great
Recession, but even if it were ineffective, I don’t see how it could have been
detrimental to the recovery.

This relatively trivial critique only confirms the success of the
CB strategy: of course, no matter how much of a profitable trade you put on,
you end up wishing you had it in a larger size.

It’s possible to debate whether the trading success of the CBs can
be evaluated on the same scale as that of other market participants. On one
hand, the CB buys and sells at market prices as everyone else, and their
product, fiat, is transparently presented. On the other hand, they are embedded
in their government, flanked by politicians, the military, and law enforcement
who protect their credibility.

Fair or not, one has to play the hand they are dealt.

And the central banks are not just playing the game well….THEY

Good luck,