Years of permanently 0%-ish low-risk real returns

Possible long term vs probable short term

My base case for the long term outcome of the giant ZIRP/NIRP experiment being conducted on all of us (to bring about growth and moderate inflation), is that NIRP will not succeed, but will eventually lead to helicopter money that will do the trick (and overshoot on the “moderate inflation” part enough to make a lot of central bankers whisperyell “I told you so!” behind closed doors).

However, it will take time for helicopter-based solutions to become mentionable in central banker polite conversation and even more time to start to get implemented in the same way hedgehogs mate – carefully. So the results, if this happens, are probably years out.

There’s also the chance that I’m mistaken and there will never be helicopter money. Maybe the economic circumstances will not be bad enough to warrant mandate tweaking for the major central banks. After all, if “sub-optimal” or “below potential” is the worst the developed economies are going to see, then the pressure to do something radically unconventional will probably not mount. Or maybe central bankers will find this idea too dangerous or unpredictable and will opt for watching the world burn slowly and in a controlled fashion.

So either way, we’re probably stuck in years of dismal growth, nonexistent inflation and negative interest rates and other measures to get money supply and velocity up. Money will continue to be abundant.

Risk-free assets will cost you, low risk will yield almost nothing

Demand for money is low, supply is large and getting larger as time goes by. While this is pushing up the price of a lot of assets, macroeconomic uncertainty and low expectations of future growth and inflation are disproportionally concentrating demand in assets perceived to be safe. This has manifested itself already in assets that are considered “risk-free” (or the closest thing to it), ie government bonds of highly rated sovereigns. Starting with short term government debt, yields are now going down on bonds with longer and longer durations. Japanese and German government bonds have negative yields 10 years out, while Swiss government bonds across the entire duration spectrum are now at negative yields. The rest of developed market sovereign bonds, while not at negative yields (yet), return almost nothing. This signals a strong preference for return OF, rather than return ON, capital.

However, the yield on government debt cannot go significantly negative without negating it’s “return OF capital” characteristic, so this clamoring for safety will result in price inflation (and therefore, yield deterioriation) across an ever expanding group of assets up the preceived risk ladder. Investment grade corporate bonds have seen their yields already fall considerably, while Unilever in spring issued a multi-year bond with 0% coupon. This trend is likely to continue, eventually fueling the price appreciation of assets, where the likelihood of loss of capital is considered small. From quality corporate bonds it will likely expand to infrastructure (prime suspect for shelter in macroeconomic malaise), equities (consumer staples companies and generally strong franchises spring to mind) and real estate. Not sure how it will affect commodities, but a rising tide tends to float all boats, even the ones without an engine.

The result

  • Every low-risk instrument that used to yield something, will yield very little, sometimes nothing.
  • Large corporates: financial engineering in the form of buybacks will increase EPS, nonexistent debt service costs will help inflate profits and valuations will seem more reasonable than they really are.
  • Governments: they get to continue with business as usual for some time without any pressure for significant welfare or tax reform. Stronger sovereigns will switch out some of their expiring debt stock, effectively reducing their debt/GDP ratio by virtue of 0-coupon bonds sold at a premium.
  • Investors dependent on investment income will feel considerable pressure to adjust their living standards down.
  • Insurance companies and commercial banks will have a hard time making any money.
  • In general: asset price inflation will continue, consumer price inflation will not pick up and this will go on until either a deflationary earthquake where almost nobody wins or a helicopter-based solution which succeeds in bringing about inflation and only destroys the creditors, facilitating a necessary transfer of wealth in the process.

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