Can Interest Rates Ever Go Up Again? ZIRP Forever?

[pmward]

I'm going to challenge the very foundation of your thesis that everything else is built upon.

> My understanding of our macroeconomic situation is that in order for long-term interest rates to increase, we need to deleverage our economic system.

Can deleveraging happen in a higher interest rate environment? Say inflation picks up and is running at 5% per year, but bond yields are suppressed at 4%, is that not a deleveraging? Slowly inflating away the debt? This is the same tactic we used in the post WWII era, and one we are currently using. ZIRP obviously helps this case, but it doesn't have to be 0, so long as the number is below inflation for an extended period the government essentially becomes the one that gets compound returns on their debt and bond holders get a compounding expense. By the time the inflation mess came to a head in the 80s, our debt was inflated away and so low that they could jack rates up to the sky. Eventually our current debt will be inflated away as well. This is all a part of the cycle.

[LittleDinghy]

Can deleveraging happen in a higher interest rate environment? Say inflation picks up and is running at 5% per year, but bond yields are suppressed at 4%, is that not a deleveraging? Slowly inflating away the debt? This is the same tactic we used in the post WWII era, and one we are currently using. ZIRP obviously helps this case, but it doesn't have to be 0, so long as the number is below inflation for an extended period the government essentially becomes the one that gets compound returns on their debt and bond holders get a compounding expense. By the time the inflation mess came to a head in the 80s, our debt was inflated away and so low that they could jack rates up to the sky. Eventually our current debt will be inflated away as well. This is all a part of the cycle.

pmward, is there a book or book chapter, or paper you would recommend that discusses this cycle?

Also, by "...and bond holders get a compounding expense," do you mean that, whenever the bond interest rate is less than inflation, bond holders are paying a "compounding expense"? If so, is this an expense that can help reduce one's taxes in some way? I imagine not, but just asking. Certainly it is a "compounding loss."

The big question for me right now is whether, if the interest on T-bills (and maybe 1-3 year T-notes) goes negative, should PP and GB holders still buy T-bills and 1-3 year T-notes for their cash assets? I've got T-bills maturing quite frequently; normally I would turn around and buy another T-bill, but in a negative interest rate environment, I'm not so sure whether that is what I should be doing. Maybe I should just keep cash in hand (bank). Your comments (and Tyler's article) today from another thread "The Permanent Portfolio May Be About To Break" (viewtopic.php?f=1&t=10446) below, though about bonds, may seen to hint that PP and GB aficionados should continue to buy T-bills even if interest rates are negative, but I'm really unsure. Your thoughts...?

Might I introduce you to Tyler's wonderful article on bond convexity: https://portfoliocharts.com/2019/05/27/ ... convexity/

Combine that with the fact that gold is highly correlated to negative real interest rates, and the fact that lower risk free rates correlate to higher stock multiples, and I don't think you have anything to worry about at all. This could actually be one of the BEST times to hold the PP.

[pmward]

pmward, is there a book or book chapter, or paper you would recommend that discusses this cycle?

Navigating Big Debt Crisis by Ray Dalio

Also, by "...and bond holders get a compounding expense," do you mean that, whenever the bond interest rate is less than inflation, bond holders are paying a "compounding expense"? If so, is this an expense that can help reduce one's taxes in some way? I imagine not, but just asking. Certainly it is a "compounding loss."

Unfortunately, no. Inflation is a hidden tax, and it cannot be claimed as a loss. Governments love to inflate away debt for 2 reasons. First, it is political suicide to increase taxes to the point necessary. Second, a government surplus necessarily means a deficit in household and/or corporate sectors.... which is a bad thing. Both sides of the balance sheet must balance. If someone is going to have a surplus, someone must have a deficit. To put households and/or corporations into a deficit is terrible for the economy. Ask Germany how trying to do this has been going for them the last couple of years.

The big question for me right now is whether, if the interest on T-bills (and maybe 1-3 year T-notes) goes negative, should PP and GB holders still buy T-bills and 1-3 year T-notes for their cash assets? I've got T-bills maturing quite frequently; normally I would turn around and buy another T-bill, but in a negative interest rate environment, I'm not so sure whether that is what I should be doing. Maybe I should just keep cash in hand (bank). Your comments (and Tyler's article) today from another thread "The Permanent Portfolio May Be About To Break" (viewtopic.php?f=1&t=10446) below, though about bonds, may seen to hint that PP and GB aficionados should continue to buy T-bills even if interest rates are negative, but I'm really unsure. Your thoughts...?

First and foremost your cash bucket is for liquidity. If it costs you money to place it in one place, but it does not in another, then certainly take the place that doesn't charge you. In a negative interest rate environment at first the banks will likely take the loss to try and keep your funds. But at a certain point they are bound to start having bank accounts be negative yielding as well... because they can only lose so much for so long. So there are numerous things you can do to try to reduce the impact. For me, my first step was to start rolling from 1 year bills to 3 month bills as soon as we went negative real yields, as it simply is not worth locking money up for a full year for a loss after inflation. If nominal yields go negative I'll look for other options, like a plain old savings account that might not be negative yet. It's almost comical though, you look at this forum and we spend so much time trying to optimize cash... at a certain point we do start splitting hairs. We also likely do not get a reward out of trying to optimize cash that is worth the time and effort we put into trying to optimize it...

[LittleDinghy]

Thank you pmward. Very helpful indeed.

[D1984]

Might I introduce you to Tyler's wonderful article on bond convexity: https://portfoliocharts.com/2019/05/27/ ... convexity/

Very good article! It is something I'm aware of, because I'm familiar with the duration calculation. It's not that I disagree here, it's that our base assumptions differ.

Tyler assumes bond rates can go to -3% (or at least, he graphs them as such in that article).

In my mind, once 30-year bond yields hit -1%, the cost to cash out federal reserve notes and stick them in a vault becomes attractive relative to the 1% cost of keeping the money in the bond.

To put things in an extreme perspective, suppose interest rates on 30 year bonds hit -99%, such that you'd be left with 1% after each year. Imagine you started off with $1M and after the one year period, it was only worth $10k. Certainly, you can rent out multiple safe deposit boxes and find some niche insurer to write a policy on safe-deposit boxed cash of $1M for less than the $950k that you're losing by holding the bond.

Or, you would just spend the money on something else, a business, a stock, gold, etc.

Of course, I don't believe Tyler or anyone would argue that long-term interest rates could drop to -99%, I am not erecting a strawman argument to bash down. I use it as an extrapolation to highlight my point that at some point, the yield simply cannot go any more negative because the alternative cost of building a vault and hiring armed men to sit and watch the federal reserve notes is cheaper than the loss from holding the negatively-yielding bonds.

I argue there is a defacto floor to the negative interest rates bonds could have. I don't know what that floor is, but I've been following Tyler's post for quite some time and a brilliant man like him could probably estimate it with a few hours of research.

There must be economies of scale for large institutional investors to take possession of 10 Billion in FRNs and put them in a vault somewhere. Smaller retail investors would stick cash in safe deposit boxes or max out iBonds/eeBonds, FDIC 0% yielding savings accounts, or some other tools that institutional investors do not have access to.

I bet some Wharton-trained hedge fund analyst, or possibly several dozen across the world, have performed such a calculation and decided the floor to 30-year US Treasuries is X%. I'd guess it's around -1% but that's a ballpark figure.

And suppose we could estimate that floor with fairly high certainty, then, convexity aside, it would make no sense for a retail PP investor to hold any long-term bonds at that point, because at that floor of equilibrium where any further drop in negative yield results in institutional investors cashing out FRNs into a vault, then there's zero capital gains for a PP investor to have, and there are likely better sources to put the money that at least give 0% yield (not resulting in a loss at least), and wait for interest rates to rise before buying back in.

As I type this out, I realize my "Is the PP Doomed" thread a bit premature because interest rates are only 1.25% as of Friday. I think the PP could still work down to -0.5% at the very least, due to the convexity, and due to the fact that "only" paying the federal government 0.5% to store cash for 30 years is cheaper than renting a vault, securing it, transporting it, and insuring the cash from rot, theft, fire, etc. So it's perfectly reasonable that institutional investors would continue buying LTTs of 30 years with rates down to -0.5% and possibly lower, but how much lower? And at that point, we retail PPers must exit the position for cash until interest rates rise.

The above is all well and good but you are assuming that cash is such that a $100 bill will always be worth $100 (and I don't mean that you are presuming that in inflation-adjusted terms it will always be worth that much....I mean you assume that it will always be worth a nominal one hundred dollars) and--barring hyperinflation which is not exactly a concern given a deflationary secular stagnation economic world where rates are below zero as you are hypothetically proposing--can not be worth less than that. In fact, it easily could be; the government could make it so and here's how:

Hypothetical situation: Presume the interest rate that is needed to fully employ the economy's labor/capita/resources is a negative one (if you do an IS/LM model and draw a supply/demand curve for loanable funds at a given interest rate the rate can be positive but there's nothing that says it has to be positive). The government (and the Fed) realize this but can't cut rates much below -1% or -2% due to people just holding physical cash as above if rates get too low. Solution: Make holding physical cash just as "painful" in financial terms as holding negative-yielding bonds/bills/bank accounts. All the gov and central bank would have to do would be either:

A. Impose a slight "haircut" of a few percent on any cash turned into banks to be deposited (i.e. if you deposit $1,000 in cash it is only worth, say, $990 or $980 in electronic money...or however much of a haircut is needed to make holding cash less attractive than holding negative-yielding deposits). Any time you try to deposit some of your cash into a bank you lose a little bit of it. Any merchant who accepts cash will have to hike his/her cash price vs credit card/debit card/check price to make up for the fact that said merchant will also get a financial haircut when he/she tries to deposit the funds. Pretty soon holding/using cash becomes less appealing than just putting the money in the bank, T-bills, or T-bonds and losing a few percent a year,

or,

B. Simply announce that on December 31st of each year there will be a Powerball-type (or draft lottery type) drawing of numbered balls and any physical currency that has a serial number ending in the number/s of the balls drawn will instantly become voided, worthless, and no longer legal tender. If they wanted to instantly void, say, 10% of the outstanding currency they could just use the last digit of the serial numbers (assuming the last digits of currency serial numbers are roughly evenly distributed such that each number from 0 to 9 makes up approximately 10% of said last digits); if they wanted to do less than that (say only void 1% of outstanding physical currency) they could just do it by choosing two numbers--one for the next-to-last digit and one for the last digit--and announce that any bills with serial numbers ending in these two digits are now void. Given enough chosen combinations of digits the government could void anywhere from 0.0000001% or less of the total outstanding physical currency to half or more of it. Of course, a savvy cash-holder could deliberately choose to hold $100 bills each with a different combination of digits in the serial numbers in order to minimize the chance of his money being all voided but in doing so would (assuming he had several thousand or so of these hundred dollar bills or more) virtually guarantee that some of it would be voided; by diversifying the serial numbers he holds he has traded off the slight probability of a catastrophic loss--all his money becoming worthless at once--for the near certainty of a small loss since if he had enough Benjamins at least some of them would no doubt have the "blackballed" serial numbers. At this point we are back to square one; if you are essentially guaranteed a 2 or 3 or 4% loss by holding paper currency then why not just hold electronic savings/checking deposits, T-bills, or government bonds even if those do have a negative yield (and please keep in mind that the government could choose to void, say, 3% of the currency each year....that would make holding savings instruments--bonds and the like--with a negative yield of -1% or -2% an attractive choice by comparison....and the government could just stop issuing I-bonds and savings bonds if it so chose)?

Am I suggesting the government SHOULD do this? No. Am I saying they MIGHT do this if at some point they get into a tight spot, we have a demand collapse, hardcore chronic deflation sets in, and negative yields are needed to create full employment? Yeah, well, that's certainly a possibility. Who knows what the future holds.

[Hal]

D1984, have you been consulting for the IMF as a second job?

https://www.imf.org/en/Publications/WP/ ... uide-46598

https://blogs.imf.org/2019/02/05/cashin ... ates-work/

[pmward]

In my mind, once 30-year bond yields hit -1%, the cost to cash out federal reserve notes and stick them in a vault becomes attractive relative to the 1% cost of keeping the money in the bond.

The problem in your thinking is that you are thinking of this only from your perspective, as a small individual retail investor. Individual retail investors honestly are a drop in the bucket. We don't really move the needle much in any direction. It's the institutions where most of the cash is held, and the cost to store cash (not to mention the limited amount of physical cash these days) makes this impossible. The "effective lower bound" of interest rates is estimated to be around -10%. At that point burying cash becomes an arbitrage opportunity (approx 10% would be damaged by elements or found and taken by someone else). Let's also not forget to mention that other countries with negative rates have considered paper cash that has a depreciation schedule written on it to make even storing cash a moot point. Rates can go MUCH lower than you assume. I mean 10 years ago nobody ever would have thought negative rates would be possible, period. Now people say negative rates are possible, but no less than 1%. 10 years from now are we going to be saying negative rates are possible, but there's no way it can go below -5%? Your bonds have a lot more potential upside than you give them credit for. Moreover, once interest rates actually go negative, it kind of becomes self reinforcing at that point, both in the fact that governments love it, and in the fact that investors get hooked on how much money they are making in capitol appreciation. Negative bonds have done incredibly well in EU and Japan in recent years. These investors are making MORE money off their bonds when they are negative than they did when they actually paid a yield. Japan and EU already have proven Craig's doubts about low interest bonds as false. The data is out there for you right now to go see how well bonds (and the PP as a whole) have performed for them in this environment.

[I Shrugged]

-10%?
Where's my pitchfork?.....

Honestly it is such uncharted territory that I think it just can't happen. Things we can't forsee will force the hands of governments.

[pmward]

-10%?
Where's my pitchfork?.....

Honestly it is such uncharted territory that I think it just can't happen. Things we can't forsee will force the hands of governments.

In this crazy world today all bets are off. The worst thing we can ever do is let the biases of what we feel "should" happen blind us from the possibilities that "could" happen.

[I Shrugged]

-10%?
Where's my pitchfork?.....

Honestly it is such uncharted territory that I think it just can't happen. Things we can't forsee will force the hands of governments.

In this crazy world today all bets are off. The worst thing we can ever do is let the biases of what we feel "should" happen blind us from the possibilities that "could" happen.

On that we agree. I love the HB saying, “Anything can happen, and nothing has to happen.”

[pmward]

Pretty much. And right now there is a real possibility of it becoming a reality. BUT, negative interest rates don't cause me fear in a PP in and of themselves.

I think the one thing we may need to at some point wonder about is the PP eventually in a long term "tight money" aka rate hiking phase. Harry always saw "tight money" phases as self limiting, but I'm not so sure they are as self limiting coming from negative interest rates. It all depends on how, why, and how fast the interest rates go back positive. I mean if they are going back positive because growth is surprising to the upside, we would at least have stocks to carry the portfolio. But in a stagflationary scenario coming from negative rates, we could enter into a prolonged phase where stocks, bonds, and gold are all going down in unison for an extended period. I do have a modified BG with 5% of my cash in REIT's, and at some point I may increase that to 10% (the only reason I'm not at 10% now is a large purchase I will need liquid cash for next spring). I *think* the REIT's would have a bit more firepower than cash in that worst case stagflationary scenario starting from negative rates to help minimize damage. Commodity trend may be another thing that would potentially help here. Either way, this is something that might warrant some discussion, even though it is far from guaranteed, and likely not something any of us would have to worry about in the near term.

[pmward]

Did some more thinking on this and want to elaborate a bit further.

So, let's use a hypothetical scenario here. Let's say interest rates are -3%. What are the ways that interest rates could go back to 5% again, and how are the assets in the PP likely to behave? One caveat that I want to place here is that currently we have too much debt for a significant uptick in rates, so this would have to be at least a few years of slowly inflating the debt down before we really could have a drastic uptick in rates, currently we are pinned low so the downside risks in bonds are actually quite limited. Rates are low for 2 reasons right now. 1 growth has been anemic since 2012 and secondly that the debt load is high. Basically we are stuck in a low growth/low inflation environment, which is putting extreme downward pressure on rates. So how can we bust out of this environment and actually increase rates?

1) Prosperity (growth increases and inflation increases): This is the best scenario. Growth picks up, and inflation comes on inline. Bonds obviously sell down, gold sells down, but equities really shine, and cash of course (as in all scenarios) slowly goes from fixed expense back into fixed income. In this scenario the government doesn't need to expand the deficit any further. Equities pretty much carry us through the mean reversion. All is good, nothing to see here.

2) Stagflation (growth stagnant or decreasing, inflation increasing): Here's is the tricky thing. In the 70's gold was able to come to the rescue here. However, from negative rates gold could either help or hurt depending on the reason and the speed of rate increase. In a stagflationary crisis like the 70's gold would do the same I believe, go up until the Fed really got serious on jacking rates up quickly and violently. It would get the fear bid. However, stagflation doesn't have to be a crisis. It could be mild or moderate. In a mild or moderate stagflation, without that fear factor, I think gold would sell as well from negative rates. Gold has went up on the way down due to increasingly negative real and nominal yields, and as yields get back to positive in real and nominal terms (and even as that spread reduces on the way up) it would likely be bad for gold. Obviously in a low growth phase stocks and bonds would both do badly as well. This is the worst case scenario for the PP, a slow, painful unwind in a low growth environment. Say over 5 years going from that -3% rate up to a 5% rate in an environment with inflation that is unpredictably bouncing between say 2-6% year after year. This would not be the self limiting "tight money" that Harry thought of. This would be a slow, painful peeling off of the bandaid over a few years. This would not be a pleasant time to hold a PP. Then again, it also wouldn't be any better for a 60/40 investor.

Potential allocations that could help (either in VP or in modifying part of one allocation to one of these):

1) Commodity Trend / Managed Futures - I think this is the best type of fund for that worst case mild/moderate stagflation. I'm not a fan of long term holding commodities other than gold. I think trend following is the way to hold a commodity allocation. Downsides: fees and the fact that currently commodities have been in the gutter for awhile now and likely will stay in the gutter the rest of the way down in rates (assuming rates continue lower, of course).

2) REIT's - I think in the mild to moderate stagflation REIT's would do reasonably well. I think increased borrowing costs on one hand would be bad for them, but increasing rents and property values would be good on the other. Downside: Just like cash this would help soften the blow (probably a bit better than cash), but this wouldn't necessarily carry the entire portfolio like commodity trend would.

3) International / Emerging Markets - if there are countries that have the growth we would be missing, it would be a good time to own them. Also, assuming the dollar is going down in this environment relative to the rest of the world, the currency spreads add a bit of juice to the portfolio as well. Downside: well we can't be sure in advance that these other countries really would be growing.

4) Value (wherefore art thou oh value factor????) - In the 70's value did very well. However, the very moment the value factor was brought to light by Fama/French it vanished never to be seen again (yet). Has it been arbitraged away somehow? Have index funds killed the value factor? I wish I knew the answer to these. If the answer is no, then the GB should get some massive help here. If however, the answer is yes...

Thoughts? Critiques? Etc?