Text size

Neither a borrower nor a lender be, young Laertes was advised. In today’s world of zero or negative interest rates, to be a lender leaves one victim to what may be described as a Polonius assault.

“For a loan oft loses both itself and a friend,” the Bard wrote in Hamlet. Yet in today’s capital markets, lenders seem more than willing to lose by investing in bonds with negative yields—which by definition return less than the original investment.

The total of government securities with negative yields has surpassed $10 trillion and continued to rise last week. The benchmark German 10-year Bund stopped just short of that mark at 0.02%—two basis points—while the Swiss equivalent costs a buyer 50 basis points and the Japanese, some 17 basis points.

Why would rational investors subject themselves to such guaranteed notional losses? The sophisticated answer is that negative-yield securities could provide a real return if there were deflation. Still, to stash cash in the proverbial mattress would seem preferable. That’s what Commerzbank (ticker: CBK.Germany) mulled doing, according to the Financial Times, rather than pay the European Central Bank 40 basis points to bank its cash. But the bank chose not to pile euros in vaults, the FT said.

Logistics may have had something to do with it. The Federal Reserve Bank of Chicago helpfully tweeted Friday afternoon that a pile of $100 bills stacked a mile high would total $1.4 billion—which suggests that financial institutions would need lots of expensive space for a bunch of Benjamins should they ever want to resort to warehousing liquidity in physical cash, rather than electronic entries at the central bank.

In comparison, the 1.64% on the benchmark U.S. Treasury 10-year note seems like an absolutely high yield, even if it is historically low. And the 2.46% on a 30-year Treasury long bond appears absolutely lush when the British equivalent pays just 2.06%, just as the United Kingdom faces a crucial vote next week on whether to secede from the European Union—with polls swinging to the exit side by last week’s end.

Why are investors around the globe flocking to securities with negligible or negative returns?

Clearly there has been a deterioration of attitudes over the past week or so, especially since the release of the dreadful May U.S. employment numbers the Friday before last. Not only is confidence in U.S. growth waning, it is being felt worldwide. In part because of interest earnings getting crushed, European bank stocks have slumped sharply. And South Korea’s central bank last week surprised by joining in with rate cuts to spur that nation’s lagging economy.

The combination of concerns dragged down U.S. stocks at last week’s end, leaving the major averages on either side of unchanged. The mood was considerably worse, however, with an uptick of options volatility (although still subdued) and, most especially, the flight to safety in low- or no-yield bonds. Jeff deGraaf, head of Renaissance Macro Research, further observed that copper hit a 65-day low, in tandem with the Treasury 10-year yield, while defensive stocks were relative outperformers.

Ahead of this week’s meeting of the Federal Open Market Committee, Fed Chair Janet Yellen Monday removed references to the timing of rate increases, which she previously had indicated could arrive “in coming months” (“Yellen Changes Her Tune on Interest-Rate Hikes,” May 28). She reverted to the mantra that policy will depend on the incoming data.

But what data? The Fed created a Labor Market Conditions Index consisting of 19 indicators. As Steve Blitz of economic advisory M Science points out, the LMCI has been sliding since December 2014, and has dropped into negative territory. Previously, in such circumstances, the Fed has cut rates, not raised them, as the consensus persists in expecting.

To be sure, the FOMC is virtually certain not to raise rates this week. What will be more revealing will be a new dot plot of committee members’ rate expectations, which had anticipated two hikes this year. The fed-funds futures market is now putting only even money on a single boost in 2016, and not until December. As our colleague Vito Racanelli points out in The Trader on page M3, the futures market has had a vastly superior forecasting record than Fed officials. The fall in bond yields and the stumble in global stocks are consistent with what the futures see.

IS DONALD TRUMP BULLISH for financial markets? No. Yes. Or maybe. Those answers are proffered by a trio of experts, and their lack of agreement might help explain why the presumptive Republican presidential nominee thus far has had little impact on the markets. Neither, for that matter, has his presumptive opponent, Hillary Clinton, who last week finally secured the requisite delegates to lock up the Democratic nomination.

Also last week, Lawrence Summers issued a jeremiad in the FT that a Trump presidency would raise the specter of a severe recession within 18 months and a global trade war. Yet other, less-partisan observers suggest a Trump presidency could boost the economy, driving the dollar and U.S. interest rates higher, hurting stocks and gold. Or there could be “helicopter money” with the Donald at the controls, letting fly a torrent of greenbacks to pay for his tax cuts and spending, boosting prices of Treasury securities and gold, but battering the dollar.

There’s little doubt about the presidential preference of Summers, who was Bill Clinton’s last Treasury Secretary. Summers asserts that Trump would threaten the nation’s fiscal stability with a planned $10 trillion in tax cuts, which could send stocks reeling. That could provoke something like the 2011 debt-ceiling crisis, when stocks fell 17%, he writes in the FT.

Even if Trump imposed just half of the protectionism he’s promised, Summers asserts, “he would surely set off the worst trade war since the Great Depression.” Furthermore, “Trump’s authoritarian style and cult of personality would surely take a toll on business confidence, which would be the best way to damage a still fragile U.S. economy.”

Gee, Larry, tell us what you really think of the Donald.

BCA Research is rather less hysterical in its assessment, as befits its Canadian base. “All three of Trump’s signature policy proposals—increased deficit-financed infrastructure spending, a more restrictive immigration policy, and trade protectionism—are dollar bullish,” writes BCA Managing Editor Peter Berezin. “The implementation of these policies could cause the U.S. economy to overheat, forcing the Fed to raise real rates more than it otherwise would.”

Protectionist curbs would reduce the U.S. trade deficit, even if trade partners retaliate tit for tat, because U.S. imports exceed exports by 25%, he continues. Political risk from a Trump administration wouldn’t necessarily hurt the dollar, since the greenback typically benefits during geopolitical unrest, as in the 2013 U.S. debt standoff. (It’s tough to keep all of those debt crises straight.) If the world decided to dump U.S. Treasuries, Berezin posits, the Fed could buy them. And, he adds, Trump would hardly be averse to any resulting dollar weakness.

The notion of a Trump Treasury borrowing full tilt to stimulate the economy, with the Fed supporting the effort by buying the bonds, jibes with the next step envisaged by economists for monetary policy after negative interest rates. Academics call this “overt monetary financing,” but it’s better known as helicopter money—from then-Fed Governor Ben Bernanke’s invocation in 2002 of Milton Friedman’s metaphor of dropping dollar bills from choppers to spur spending.

And, according to MacroMavens’ Stephanie Pomboy, “in Trumpspeak: it’s gonna be HUUUUUUUUGE.”

“Having succeeded at being too big to fail in business, he’s ready to take that formula to the next level,” she writes. “And, as much as we’d like to deny it, the fact is that we need his braggadocio and ‘expertise.’ For, default is our ONLY option—whether silent (via Fed monetization and dollar debasement) or via Trump’s middle finger—this is where we’re going. There is no other way we can fulfill the obligations we’ve made, especially after six years of financial repression.”

That would be the half-trillion dollars in unfunded corporate pension liabilities, which pale against the $3.4 trillion of state and local pension deficits if something less than the funds’ “fantastical” 7.6% return assumption is used. Adding in estimated unfunded federal liabilities, the aggregate hole is $7.5 trillion, Pomboy explains.

With no other way to meet the massive obligations to an aging population and the self-proclaimed King of Debt in the White House, policy makers would rev up the copters. And with central banks monetizing the debt and capping interest rates, “currencies again will pay the price for policy sins.” Treasuries and gold would rally, just as they did during the financial crisis, she concludes.

Sounds pretty extreme. Just like when Steph harangued her clients more than a decade ago that the massive buildup of real estate-related debt posed a clear and present danger to the financial system and the U.S. economy. And we know how that turned out.

So, if Summers is right, Trump could lead to a 1930s-style trade war and deep recession. If BCA’s Berezin is right, Trump could produce an overheated economy, with higher inflation and interest rates. And if Pomboy is right, Trump will embrace debt, just as he has in business, and foster an expansionary fiscal policy funded by printing-press money to meet the obligations to an aging population, which she sees as inevitable in any case.

In any of these scenarios, a bullish case for stocks is hard to discern. Or maybe we continue to stumble along with weak growth and low returns. That said, as Herb Stein, Richard Nixon’s sage economic adviser, observed: If something can’t go on forever, it won’t. How it ends is far from certain, however.

E-mail: randall.forsyth@barrons.com

Like Barron’s on Facebook

Follow Barron’s on Twitter