The long-term consequences of central banks’ unprecedented stimulus measures are unknown. Initially designed to pull the advanced economies away from disaster caused by the financial crisis in 2008, the unconventional monetary policies, zero, and negative interest rates now pose substantial downside risks to investors.
Central banks in Europe and Japan have moved their benchmark interest rates below zero. This, combined with investors’ ravenous appetite for bonds, has pushed the yields of more than $10tn of sovereign debt into negative territory. This is costing investors billions of dollars and forcing many to buy increasingly longer-dated or more lowly rated bonds that still offer positive yields — and has sparked concerns that investors could be exposed to painful losses if yields, which move inversely to prices, snap back up…Even a relatively modest rise in yields could cost investors dearly. Goldman Sachs recently estimated that an unexpected 1 percentage point rise in US Treasury yields would trigger $1tn of losses, exceeding the financial crisis losses from mortgage-backed bonds.
Away from the advanced economies of Europe and Asia, on this side of the ocean, while trying to normalize rates, the Fed has not fully terminated its $2.3 trillion asset purchase program, QE, which was designed to put downward pressure on short-term yields. The Federal Reserve still rolls over mature paper and purchases treasuries with the interest it earns.
“The Fed tightening gave us little worry, but the unwind of the balance sheet gives us major worries,” said Mark MacQueen, co-founder of Sage Advisory Services Ltd., which manages $12 billion in Austin, Texas. “The Fed is keenly aware that the balance sheet has a much greater impact on the overall yield levels in the markets going forward than raising rates.”
Let’s Make a Deal: Less Return With More Investment Risk
Crazy, right? But that’s where we are now. From ancient times to the present, average interest rates have never been this low. Through plagues, overthrowing of monarchs, wars, and all of histories asset bubbles, interest rates have been solidly positive, until now.
One thing is certain. The process of returning to conventional monetary policies is untested. As a value investor, I’m making sure, as much as I can, that my portfolio is stress-tested for this new paradigm; an environment where relative risk is a justification, for many investors, to reach for yield with increasingly smaller returns.
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