Comment of the Day

October 18 2019

Commentary by Eoin Treacy


Thanks to a subscriber for this memo from Howard Marks which may be of interest. Here is a section:

Eoin Treacy's view

Here is a link to the full report and here is a section from it: 

The concept behind negative rates is simple. It’s merely the reverse of the traditional norm, in which lenders receive interest from borrowers. Generally speaking, interest rates are a function of two variables. (a) the time value of money and (b) expected changes in the purchasing power of money (i.e. inflationary or deflationary expectations). (Of course, interest rates should also incorporate a risk premium to compensate for any credit risk entailed.) If, for example, lenders want a 2% annual real return to compensate for the time value of money and expect 2% inflation over the next five years, a five-year Treasury note should yield 4%. But if lenders expect deflation at 3% per year, that note should theoretically yield negative 1%.

Are today’s negative rates in Europe and Japan telling us deflation lies ahead? Or have lenders changed their views regarding the time value of money? Or are rates negative simply because government s and central banks want them to be?

I suspect the changes in how the time value of money is considered, resulting from negative interest rates, is one of the most interesting topics in the market today. We are accustomed to thinking about how money loses value through devaluation and inflation but never give any thought to the value of time. Futures and options traders need to consider the time value of money because their contracts pressing maturity profiles. However, when there is no maturity, such as with property, art, collectibles or private equity the time value of money takes on a completely different meaning.

The bubble that formed in technology, media and telecommunications stocks in the late 1990s was characterized by the phrase “earnings don’t matter”. It was the growth rate which was all important. History doesn’t repeat itself but it does rhyme. Today we are well beyond the earnings don’t matter phase. The success of earnings agnostic ETF and other momentum strategies, the multiplication of the values of private companies despite massive losses, soaring prices for art and “barn finds”, billions ploughed into new money projects where most are sure to fail. This is a symptom of a new paradigm where time doesn’t matter.

If negative interest rates remain a significant factor then the incentive to take bigger and bigger bets on speculative ventures will continue to be a promising if high risk exercise. The problem with this conclusion is we are potentially already at the end of this process. The total of bonds with negative yields is now down to $13.38 trillion from $17 trillion in August. Bonds yields are rising, wage demand growth and commodity prices are recovering. Bitcoin is looking wobbly. Even a whiff of inflation would represent an existential risk for strategies based on the view time does not matter.   

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