'Well, in our country,' said Alice, still panting a little, 'you'd generally get to somewhere else — if you ran very fast for a long time, as we've been doing.'
'A slow sort of country!' said the Queen. 'Now, here, you see, it takes all the running you can do, to keep in the same place.
From Through The Looking Glass By Lewis Carroll
Throughout the 2015 I wrote about a major misconception that most investors had about the economy. Even many of those who correctly saw the underlying problems with the credit binge taking place were still in denial about the ultimate consequences for the financial markets. As I wrote here, investors were making a major mistake by not shifting at least part of their portfolio to Treasuries as the only protection from the coming turbulence. Since then yield have cratered with 30 year UST yield dropping half a percent and prices of Treasuries soared.
Japan 10 Year Treasury Yield Trades Below 0% For First Time Ever
We are living in a historic time. Bank of Japan opened a whole new era in investment by announcing a negative interest rate policy. 6 years ago when QE was just getting started in the US a number of analysts (including our research team at RiXtrema) wrote that it will be virtually impossible to unwind. Japan’s example shows us that we were indeed correct. Japan was doing QE well before Mr. Bernanke invented it and now we see what the end game looks like. Massive asset purchases have their limits as Central Bank becomes the biggest player in the sovereign debt markets crowding out free market forces. Every next dose of QE has progressively less and less impact.
Manipulating interest rates also has its apparent limits at the zero bound rate. But Bank of Japan decided to essentially continue QE in order to try to jumpstart the economy and push down Yen by taking rates into negative territory. Will this QE4EVR work? I guess they are driven by the dictum that if you don’t succeed at first, you must try and try again. But it has also been said that the very definition of insanity is doing the same thing over and over again and expecting a different result. What is most amazing about this desperate move by BoJ is that markets did not go for it. Yen continued to fall and Nikkei crashed 5.4% on February 9th suggesting that central banks are close to losing credibility as I have suggested here.
That will likely not stop ECB from trying its hand at the negative rates and Fed cannot be too too far behind.
The question in my mind is not if this economic twilight zone coming to the United States, but rather when. Japan, after all, had a decent head start to the rest of the world in terms of QE policies, so it may take some time to get there, but I believe we will see negative rates from the Fed. Ben Bernanke himself weight in on the topic when he said the following: “I think negative rates are something the Fed will and probably should consider if the situation arises.” And it is quite likely that the situation will indeed arise as the economy is clearly heading into a recession (if not in it already) with Fed Funds rate at only 25 basis points.
Treasury Bonds Are Still The Only True Diversifier
Despite the massive run up in prices, the upside for Treasuries is as high as it’s ever been. How could that be if rates are historically low? Aren’t rates going to mean revert? In honesty, nobody has the crystal ball and neither do I. But is important to understand that correlations between US treasuries and equities are persistently negative. When volatility hits most other asset classes see their correlations increase or get closer to one. But not treasuries. So, if interest rates do rise and treasuries fall, this would mean that parts of your diversified portfolio related to equity would also rise. Treasuries are just about the only instrument that provides true diversification. There is absolutely no reason not to hold some treasuries right now despite historically low rates.
When Will Treasury No Longer Be A Safe Haven?
But what if this thesis is wrong? What if treasuries fall together with equities as had happened in the 1970’s during stagflation. The difference between 1970’s and today is that US government debt underpins the whole financial system to a much greater degree than it has ever before. Banks and pension plans hold massive amounts of treasuries as a safe haven asset. If rates rise significantly this will mean massive losses throughout the financial system and if those losses are compounded by losses in equity markets, that would be an unprecedented financial upheaval. And many investors would have big problems getting their money back due to insolvency of financial institutions. So, losses on treasuries would not be the biggest problem investors are facing in that eventuality anyway.
Summary: Make some room for treasuries in your diversified portfolio. Rates still have lots of room on the downside and U.S. rates are actually relatively high compared to other developed countries. All other sources of yield are likely going to be extremely volatile in 2016. Prepare your clients for a period of low returns and volatility by running portfolio crash tests.
Daniel Satchkov is president of RiXtrema, a risk modeling and consulting firm, and creator of Advisor BioniX, the first risk-aware robo platform for advisors.