Why would anyone choose to live in a bizzaro world with negative interest rates?
Jhordan Dorrington, host of FinPipe’s very own The Dorr Report, speaks with esteemed colleague Brian Carney, Portfolio Manager at Canso Investment Counsel, who might shed some light on this phenomenom.
Video transcript is provided below:
Jhordan Dorrington (JD): Brian, welcome to the show.
Brian Carney (BC): Great to be here, Jhordan. Congratulations on your new show.
JD: It’s good to have you. Brian, let’s dive right in to some questions. Understanding that there are some knock on effects to administering negative interest rates, why is this still an option for central bankers? Why are we seeing this across the globe?
BC: Well, the reality is central bankers have a limited number of options to stimulate economic activity. That’s their prime objective, and there’s no proof, at least as of yet, that negative rates do not work. So as long as central bankers believe lower interest rates stimulates economic activity it will still be part of their toolkit.
JD: Can you talk to me a little bit about investors and how long and negative interest rates not only affect what’s in their portfolio now but what they might be looking to buy in the near and medium future?
BC: You know, it’s a great question, because in these types of markets investors are really challenged when it comes to fixed income options, savings options, and I would say investors are broken up into two camps. There’s the one camp, relatively small, the cynical, skeptical investor who really can’t believe interest rates should be negative and therefore sits on the sidelines or takes a more defensive posture. And the other camp, which is probably much larger, that group of investors that doesn’t want to be left behind, and no matter how challenging the markets think they have a way to outsmart those markets. And unfortunately in a negative interest rate world it means buying securities that are already yielding negative returns and hoping that they yield even more negative returns and therefore realizing a capital gain on those securities.
So it’s a challenging market and unfortunately we think the skeptical investor is better positioned to weather it but there are fewer skeptical investors than the optimistic ones.
JD: FOMO. Fear of missing out.
JD: We haven’t seen negative rates here in Canada or in the United States, but we have seen it in Japan, Switzerland and in the Eurozone. How does this affect the North American economy and do we anticipate either the Bank of Canada or the Fed also adopting negative interest rates?
BC: The short answer is we don’t see either the Bank of Canada or the Federal Reserve taking interest rates into negative territory, and the reality is the economic situations that exist in Canada and the US versus Europe and Japan are in our view distinctly different. You’ve got very anemic economic growth in Europe and you’ve had that situation for a long period of time which is why the ECB and other Central Banks have taken rates into negative territory in an effort to stimulate positive economic growth and to bring at least a modest level of inflation back into Europe.
In Canada and the US, the economic situation is quite different. The GDP numbers are modest but still quite positive. Unemployment rates are very low by historic standards. So we don’t see the need to take rates considerably lower than where they are to stimulate activity because the economies actually are doing quite well on their own.
That being said, in the last several months the Federal Reserve has cut rates three times, total of 75 basis points or 3/4 of 1%, in what they are calling a pre-emptive move to hopefully stimulate even more economic activity. But again they are stimulation off a pretty positive base, so we don’t see the same negative interest rate phenomenon happening in North America as is happening in Europe and Japan.
JD: I guess what we all want to know is, how does this all end Brian?
BC: Jhordan, I wish I had the answer to that. And we’ll have to wait and see. The central bankers will have to wait and see. Unfortunately my view, and the view of the firm that I work for, is ultimately negative interest rates are unsustainable. At some point you will have to see a normalization of interest rates which means a move from negative to positive. And what means for investors in fixed income securities is significant capital losses, as securities that they bought with negative yields move to positive and the value of those securities fall significantly.
We think investors need to be very, very cautious because we don’t see how this ends well when rates ultimately normalize.
JD: And a quick follow up question and our last one, how can investors be positioning their portfolios now to protect against the normalization situation that you mentioned?
BC: Having said what I just said, I realize that’s quite Draconian. There are ways for investors to protect themselves and earn what are modest returns by historic standards and one of those ways is to buy higher quality, floating rate notes in Canada so you can earn yields somewhere between 2-3% in very defensive instruments – that’s positive 2-3%, not negative.
We would also caution against reaching for yield into lower credit quality instruments. So, non-investment grade securities, or what Michael Milken dubbed high-yield or junk bonds. You can earn higher returns on those in the short-term but we think long-term there’s a lot of risk in those markets. So we would urge investors to be more defensive in these types of markets and wait for markets to normalize and then take advantage of those opportunities.
JD: Thanks a lot for your time, Brian, I appreciate you being our inaugural guest and expert on the show.
BC: It’s been a real pleasure Jhordan, hope to be back.
JD: That was Brian Carney. Not everyone understands how this works and we certainly don’t know how it’s going to end. But, in the same way that an investor looks for the difference between price and intrinsic value we do encourage you to also look for the difference in what’s happening around you and what actually makes sense. Because in a world of corrections it seems to be not a matter of if but when.