Odd Lots - What Negative Interest Rates Mean for the World

Episode Date: August 12, 2019

The amount of negative-yielding debt keeps climbing and now includes bonds issued by emerging market countries and some junk-rated companies. On this week's episode, we talk to Viktor Shvets, Macquarie's Head of Asia Strategy, about why interest rates keep getting lower and why that's a problem for the global economy and financial system. He argues that undermining the 'time value' of money–or the principle that money available now is worth more than money in the future because you can use it to earn additional money–won't lead to economic growth. In fact, he says, negative rates are going to end up leading to a rethink of modern capitalism and political society once people realize they have big consequences. He's also one of the few sell-side analysts who takes Modern Monetary Theory (MMT) pretty seriously.See omnystudio.com/listener for privacy information.

Thanks for listening to Odd Lots. Follow the show on Amazon Music for more future episodes or just ask Alexa, play the podcast, OddLots on Amazon Music. Hello, OddLots listeners, it's Joe Wisenthall. Before we get to today's show, I wanted to let you know that Odd Lots is hosting its first ever live event on September 19th here in New York City. Join me and Tracy Elway as we host an all-star lineup of guests to talk about Cryptocurrox. currency, white-collar fraud, modern monetary theory, and more. We'll even have some finance-themed live music, including some songs by yours truly. So keep listening to Odd Lots all this month to find out more details about the live show, but for now, mark your calendars for Thursday,

September 19th for the first ever Oddlot variety show. Hello and welcome to another episode of the Odd Lots podcast. I'm Tracy Allaway. My co-host, Joe Wisenthall, is away. But, I was thinking the other day, and I realized that Joe and I have never really done an episode on negative interest rates. And while we've had instances of negative yielding bonds before, over the course of the summer, this has actually become a really big topic. By some estimates, the world has, I think, $17 trillion worth of negative yielding debt now. And that includes things that you wouldn't really expect, like corporates, some emerging market governments. And I

think the reason this gets so much attention is that there's something fundamentally kind of unsettling about negative rates. It just doesn't really sit well with our idea of how capitalism is supposed to function. I mean, if you have money and you put it to work by investing in a company or a government, then you are supposed to be rewarded for that. And that's one reason, I think, that we're really starting to see people question the foundations of the global economy, and we're also starting to see people look at new ideas for fixing it, such as modern monetary theory or MMT, which is something that we have discussed on odd lots before. Now, in any case, it doesn't seem like negative rates are going to go away anytime soon, given that central bankers around the world are pushing benchmark rates

even lower by embarking on another easing cycle. So on today's odd lots, we'll be asking why exactly is this happening? Why is it that more than 10 years after the financial crisis yields are trending even lower? And what is this say about the economy and how we think about it and how can we actually fix it? And I'm really happy to say that our guest for this episode is one of my favorite analyst. I've been reading his research notes for many years now. And I think he's really one of the few on the sell side that thinks about these kind of issues on a big picture basis. He's certainly the only analyst I've read who seems to be taking MMT very seriously, and you'll see what I mean in just a minute. So without further ado, I'd like to bring on Victor Schwetz.

He is a global markets head of Asia strategy over at McCory. Victor, so nice to have you on the show. Thank you. Thank you for having me, Tracy. Let's start with that number that I threw out earlier. 17 trillion of corporate and sovereign debt with negative yields. How exactly did we get here? Well, that's a great question. You're absolutely correct. The question is why we cannot tolerate things like or something like utilities anymore. When I was a younger man, quite often spreads will move 50, 60 bips very easily.

Today, when we have 20, 30 bits, spreads suddenly moving, you almost need ambit. at the exits. Why can't we have price discoveries? Why can't we have time value of money? The answer to me is leveraging. In other words, our solution to low productivity rates over the last 20 or 30 years was to bring future consumption to the present. Our solution was asset prices and leveraging will deliver to you what wages no longer capable of giving you. And therefore, Yes, your real incomes might not grow, but we will allow you to grow wealth in different ways. And initially, it's incredibly stimulating. It improves wealth.

It does all sorts of wonderful things. It also works together with globalization. You can't really have that sort of leveraging unless you also globalize the product and labor market. So it's really the next of triple package of globalization, product market, labor market, and financial market where our well-being, our pensions, and everything else depends on asset prices. But the challenge with that is that the more you financialize, the less effective it becomes. You go to 20, 30 years ago, you needed maybe a dollar, $1.50 of debt to generate $1.00 of GDP. In most countries today, you need $3 to $5 of debt for every dollar of GDP.

So the more you do it, the more incremental impact diminishes. And that implies that you have to spur or you have to motivate debt to multiply even higher. To do that, you need to issue more and more of that debt. And the more capital you create compared to what you need, the more cost of capital has to go down. And that's why interest rates have to continuously go down to a low and low level. And the more you rely on average. And the more you rely on average. assets and debt, the less comfortable you are with volatility, the less you can tolerate volatilities, particularly in asset classes. So where is the stage that it's like a squirrel in a wheel? You can't stop running because if you do, the whole house of cars collapses very, very quickly. And so if you sort of think that we do that any inoculation that central banks might want to do in terms of lowering rates, in order to spur a little bit more, gross makes it worse, and interest rates have to go even lower. Over the longer term, of course, what it means, if you continue to use monetary levels, interest rates will have to go negative

everywhere, not just in Europe, not just in Japan, but also in Anglo-Saxon countries, and eventually a lot of people will say, but Tracy, as you correctly said, that's not the way capitalism is supposed to function. That's not the way corporate finance theory is supposed to function. So Victor, on that note, you talked about central banks driving down the cost of capital in order to boost growth. And this is where we start to see the impact on both our theory of capitalism and also the value of money. You mentioned this already, the time value of money. So this is the idea that money available right now is worth more than that same money in the future due to its earning capacity. So basically, you know, it's a core principle of investing that your money can earn interest or a return.

And so it's worth something. And that seems to be what makes people so uncomfortable about the negative interest rate environment. So my question is, what is that going to do to the overall economy and to investment? Central banks do what they're doing because they're scared of deflation. Now, why are they scared of deflation? Well, because we've accumulated so much debt that nobody will ever be able to repay it. I mean, globally, we have $200 trillion of debt. If you look at all of the derivatives of the instruments that we have on top of that,

really the cloud of finance is at least $400,000. That's around five times nominal GDP. So instead of repaying the debt, society is built around the concept of a very gradual and slow default. So we're slowly defaulting on our debt. And the way we defaulted is through inflation. That's why central banks are so scared of deflation. The more you rely on monetary levers, the more you drive the cost of capital down,

the more you create deflation. So you're trying to eliminate it, but you're actually making it worse. Now, why is it so? Well, a couple of reasons. Reason number one is that the low cost of capital means zombie companies survive, so you don't actually have clearances, which a normal capitalist system will have. Now, that's a highly deflationary element. The other thing that is happening, the lower cost of capital implies that any unicorn, any brand new idea can be funded. And so technology is actually

progressing much quicker than otherwise it would be the case. We've actually pouring kerosene on the fire. And as technology explodes, companies get decently mediated from their products, their brands, labor gets disintermediated from their wages, and that's also highly disinflationary. So the first side effects of using sort of monetary levels that aggressively is that you're trying to avoid deflation, but in fact you're creating stronger and stronger defamation. So actually, Victor, you just mentioned tech investment in particular, and I wanted to press you on this topic because it does feel like nowadays with the cost of capital. So low and people chasing future asset price growth rather than value right now. It does feel like

we've seen a lot of money go into the tech sector, whether it's through the private market and unicorns or through the public markets, through fang stocks like Amazon and Apple. What does the tech investment in particular do for global economies and for society? Tech investment actually has clearly multifaceted impact. Some of it is very, very good. But a lot of it is highly deflationary. So in other words, TAC has a tendency of eroding cost of everything we consume and we produce. So when marginal cost decline over time, the prices also drop. That's part of the reason it's so hard to prosecute technology company for antitrust violation because they're not actually gouging consumers. On the contrary, they're reducing prices. It's not that they're depriving consumers

of a good product. Product is actually good. The problem with tech is not so much gouching or depriving people of value, but rather the fact that tech is monetizing people themselves and the creating scale of business that includes other businesses going into this particular area. But from a macro perspective, if you keep the cost of capital too low, technology propagates much faster. So technology is really human spirit. It's human ingenuity. But the speed with which it progresses depends on the cost of capital. The lower your cost of capital, the faster it goes. As I said

a second ago, it's like pouring kerosene on the fire. And when tech progresses, it basically disintermediates companies from their products and their brands. It disintermediates employees from their wages. So it contributes more disinflation to the system. I mean, I'm curious. You've alluded to this already, but rampant disinflation, disintermediation through technology, the financialization of assets and a bunch of investors basically pursuing speculative wealth. What is that due to political society? One of the things it does is, that it increases income and wealth inequality. Again, income and wealth inequality is a variety of reasons, but financialization, relying on assets, relying on leverage, magnifies those income and wealth

inequalities significantly. Even the central banks increasingly starting to realize that aggressive, prolonged usage of monetary leverage is not good for inequalities. Now, that by itself is starting to to create political friction. So from a societal perspective, a couple of impacts. Number one, the marginal pricing power of labor decline. In other words, technology and financialization reduces your marginal pricing power, reduces your wages effectively that you otherwise would be able to command. And the second thing, it does.

If you're a person with a lot of assets, particularly financial assets, your wealth, your net worth is growing very fast. If you're relying on wages and household chattels like houses or refrigerators, your relative wealth actually goes down. And financialization and debt increase the speed with which those two parties go apart. That's your top 1% versus the rest of 99% of the population. So if we continue to rely on monetary levels, implications are that first of all, disinflation is likely to get stronger. Number two, the pockets of growth in economy will get smaller and narrow.

Number three, there will be less productive investment, a lot more speculation occurring. Number four, income and wealth inequalities are going to increase. But another thing it does, because every time you use debt, marginal utility of the investment, that debt goes down. In other words, every time we need more and more of it, what it does make countries want to do is to steal from their neighbors. So in other words, countries then start competing very aggressively to start running current account surpluses to try to steal business from another country. And that's what leads you into potential currency devaluations. That's what leads you into trade wars. So if we continue using monetary levels,

as we have done over the last 30, 40 years. If we continue over the next 5, 10 years, societies could just blow up. Okay, so here's my question. In 2019, we are about to embark on another round of easing by central banks around the world. And even though we've had 10 years of evidence to the contrary, they think that doing the same thing over and over and over again,

which is lowering rates, is somehow going to lead to a different outcome. which would be inflation. So what exactly is going to be the point at which policymakers realize that this monetary strategy is not working? Essentially, the problem is you can't throw away the system until you build a new system. I do believe that whether it's central banks, whether it's treasury departments, whether most of the banks, they do understand that you can't just keep going. But the problem is you can't abandon the system. that you already have before you've decided what else you're going to do. Now, there are alternative ideas, and the interesting thing that I find, how quickly they're

becoming popular. If you think of modern monetary theory, it's not a new idea. It's been around for a long, long time, and there were books published, the articles published for decades. It's amazing how popular they're suddenly becoming. I mean, financial times only a couple of weeks ago devoted the entire page discussing MMT. Only 12 months ago, I can't believe that ever would have happened. The same applies to Neokensians.

If you think of growing popularity of people like Paul Krutman, what you're seeing that massive intellectual shift is already underway, recognizing that fiscal, neocanian and MMT solutions might have lower side effects. It's still a drug, but it's a drug which will have lower side effects than continuing to use monetary levers. I'm not suggesting for a second we're going to abandon monetary policies where we're not. It's just what you prioritize as you go forward. I personally think 2020 probably is going to be the last year when monetary policy is used as a primary instrument. And the break point to me will be when we have to do something every two or three months, every two or three months. Think about it. We had a small heart attack in December 2018.

I don't know what January 2019 would have looked like if Geron Powell did not surrender on the 3rd of January 2019. Then we had another mini heart attack in May 2019. This time around, it was Federal Reserve and ECB. So the windows getting shorter and shorter, the period of stimulation or their beneficial impact are getting shorter and shorter. And so to me, it's those mini heart attacks that will continue rolling over the next 12, 18 months that will have to come to a stage that people will start shifting priorities. I do not believe anybody will call it Neokensian immediately or anybody will call it MMT immediately.

Rather, we're going to stumble around, and gradually it will be fiscal policy. It's going to be New Keynesian policies that are going to drive it. The news doesn't stop on the weekends. Context changes constantly. And now Bloomberg is the place to stay on top of it all. Hi, I'm David Gurra. Join us every Saturday and Sunday for the new Bloomberg this weekend. I'm Christina Ruffini.

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Listen on Bloomberg Radio. stream the show live on the Bloomberg business app or listen to the podcast. That's Bloomberg this weekend. Saturdays and Sundays starting at 7 a.m. Eastern. Make us part of your weekend routine on Bloomberg television, radio, and wherever you get your podcasts. What about political opposition to fiscal solutions? Because it does seem that basically what you're talking about is rethinking the way the financial system has been working. And governments in the developed world really.

have seemed reluctant to do that so far. And certainly it feels like there are interest groups or politicians out there who basically, I can't see them diving headfirst into MMT, for instance. So what would allow it to happen now? You argue that in some of your research that Japan is actually the closest example we have to a sort of MMT or fiscally driven society. But, you know, As someone who grew up in Japan, I can argue that that society is very, very different to the one in the U.S., for instance. When we talk about using monetary levers, we're predominantly talking about the rest of the world outside of Japan and outside of China. China is actually using all three instruments. They're using monetary policy.

They're using fiscal policy. They're using Neokaneism. And they're using straight MMT. Japan practices elements of all of this. All of this societies are different. But one thing Tracy is you absolutely right to say that a dogma developed since, I guess, late 1970s, which basically argued that private sector is always better at allocating capital than a public sector. If you go back to 1950s and 1960s, that dogma didn't exist.

People didn't think at the time that public sector, is necessarily inferior to private sector and investment. And the reason why they didn't think public sector was inferior, because in their memory, they remembered in 1920s, in 1930s, how badly private sector are misallocated resources. It was really, I said, late in 1970s. So the problem we have, the entire system is structured around the idea that private sector is dominant, private sector is in a driving seat and around the idea that public sector is wasteful and private sector is much better allocating capital. Now, I think what New Cairns in an MMT would argue, that is not strictly true always. And in fact, there has been spectacular misallocation of capital occurring

in the private sector itself. Now, to surrender the dogma requires a very long time. So from an academic point of view, you're looking at decades before a new system will actually emerge. But from a practical perspective, from a political perspective, I do not believe for a second we're going straight into MMT. What we're going to do, we're going to de-emphasize monetary and emphasize more fiscal and Keynesian solutions. Eventually, we probably will end up with a version of MTF, but that could be a decade away or longer. So it's not going to be a one sort of, switch that we go from one policy, one set of tools to another set of tool. Instead, what we're going to do is just gradually shift towards it. A classic example of that, called the antitrust

and investigation that is starting right now in various countries on technology. In many ways, that's a Niel-Kinsey-Ansean answer. When we have management teams been criticized for payments or salaries, that's a Niel-Kinzian answer. And so what you're seeing is that, Kenzin is effectively already intruding into today's world. It's already starting to impact. But its impact is still small. We're predominantly in a monetary system. All I'm saying over the next couple of years, that impact will grow.

And the role of the state is going to increase. And that role will be welcomed, particularly by Millennium and Generation Z. And you have to remember, one third of the U.S. electorate is already Millennians and Generation Z. Within five years or six years, there will be the majority, electoral majority. The same way as Baby Boomers brought on their shoulders, Ronald Reagan and Maggie Fetcher, Millennials and Z generations will change how the role of the state is perceived. I think what we're going to see is increasing influence of those ideas. Now, that's a major problem for investment.

Victor, I take the point that this is going to be a sort of long-running transition. But whenever we talk about MMT on the show, I always have the question of whether or not MMT can work everywhere. Because to me, it feels like it's basically the purview of a few developed economies who probably have an advantage in the form of currencies that are either global, you know, global reserve currencies or considered safe haven. So can everyone around the world embark on significant fiscal stimulus or MMT? No, absolutely not. It's going to be a reserve of only some countries. I think both New Keynesians and MMT, people who propagate this ideas will agree on a couple of aspects. Number one, they will all agree that if private sector doesn't multiply aggregate demand and liquidity at a pace that society requires or society believes is appropriate, then it's

responsibility of public sector to do that. Secondly, they agree that it's not necessarily proven that public sector necessarily worse at allocating capital than private sector. But the other thing they would argue that under certain circumstances, government can do almost anything they want to. And prerequisites are quite tight. Number one, you have to have monetary sovereignty. So in other words, you have to be issuing your own currency and you have to be borrowing in your own currency. Now, that applies to United States, that applies to Canada, to Australia, that applies to UK, that applies to Japan, that applies to parts of Europe. But it doesn't apply to a lot of emerging markets. In emerging market space, for example,

it does apply to China. It does apply to Korea. But a lot of weaker emerging markets, markets, they do not have monetary sovereignty. The second argument, I think correctly, they will say that you need to have proper institutions of state so that the country borrowing and or using central bank cannot be as in Barb way or Democratic Republic of Congo, Venezuela, that they have a solid institutions of state. Again, that applies to a lot of the world, but some of the emerging market, it does not apply. And the third argument, they will say, that you need to live in a relatively decent inflationary climate. Again, that applies to a lot of developed countries that applies to some emerging markets,

but it doesn't apply to others. So you're absolutely right. There are some strict criteria. It's good to be of some size as well. So there are criteria. Not everybody will be able to do this. But if you think of the world, the countries we mentioned represent about 80% of global GDP. What happens to the countries or economies that can't make the transition to fiscal spending?

And on that note, are we basically going to be trading inequality within countries or within societies for inequality between countries? That's exactly what's going to happen. We're going to become much more localized. It's actually we're going to sort of 1950s, 1960s. So it's not going to be, of course, as sealed countries as they were back then. But nevertheless, the shades of 50s and 60s will be there. In other words, much more localized, much more protective, the freedom of movement of people will be much more restricted, the freedom of movement of capital will be much more restricted.

You'll find the government will be the major driver of economies and investments. Many people will welcome that. Also, because in this system, you don't have a lot of access. capital just looking for something to do, you might end up with a little bit less speculation. You will end up with a little bit more productivity gross rates, at least for a period of time, and that in turn would lower inequalities in your country. But what about the globalization that it implies? What about the volcanization that it implies?

Well, you absolutely right. A lot of emerging markets probably will go back to being just underdeveloped countries the way they were qualified not that long ago. When I used to be a young man, they were called underdeveloped countries. So in other words, some of the trade and capital flows that really enable the emerging markets

to prosper and develop will become much scarcer. And some of those countries might not be able to make it. So disparities between the countries, I think, will increase. Okay, and you touched on this earlier, but if you're an investor in the current climate,

you are still living in the current construct of capitalism. And it's basically one where markets are sort of driven by flows of money rather than sort of outright value or productivity. So what are investors supposed to do as they still continue to grapple with the current environment, which is one of lower rates and negative yields. It's interesting. If we just continue doing what we're doing,

let's assume no change in policies. As you correctly said, it might take a long time for politics to change. If we continue to rely on monetary levels, then investment styles become quite clear. First, bonds are always good investment. This idea that it's the end of the 30-year bull market run and bonds is just absolute nonsense. because interest rates eventually will have to go negative everywhere.

So number one, bonds are always good. Number two, financial speculation always good. As you correctly said, private equity, unicorns, flat flipping, any financial speculation is good. Number three, because disinflation is likely to get stronger and the growth will become narrow in the narrow pockets. Investing in companies that are capable of growing despite the headwinds are going to become even more popular as you go forward. That's sort of the essence of your quality

and gross portfolios that a lot of people really like. One investment style that will never work in the system is a traditional value investing. Occasionally value will pick up, but essentially it doesn't work in that system at all. If we switch across to Neokensian world, the circumstances are somewhat different. I don't believe interest rates can really go up that much, but it will be an environment, which will have a bit more inflation and gross in it. So first, the bonds are not going to be a one-way street anymore. I don't think people are going to lose necessarily a lot of money because interest rates cannot really go up a lot, but nevertheless, it's not a one-way street. Number two, because there ought to be a little bit more productivity, a little bit more inflation,

at least for a while, you're going to have more gross opportunities available to you. So the excessive price you will place on the companies that are capable of growing, despite all the headwinds, will become less pronounced. And in fact, some of those companies might get somewhat derated as you go forward. There will be times when the value will really run up because the governments will be spending more money on infrastructure. There will be spending more money on various facilities and things to do, capital investment. So some of the value will really run up and could actually be a prime investment for years rather than just for, you know, two or three months. But the thing that really will work in that sort of environment is whatever the government wants to do, which is not similar if you think of China today. That's exactly what Chinese analysts are doing. They're basically asking, what would the government do and how does it work through my system and what do they buy?

That's pretty much the way in sort of neokane MMT world is going to work, that you would need to ask yourself a question, what does the government want to do? If it's infrastructure, fine, and if it's support of consumption through vouchers, a minimum income guarantee is fine. That's what you're going to do. Investment styles are quite different. But because we're living between the two worlds, a monetary world is still with us. It's still the most powerful force that we have right now. But the other world is gradually intruding. And as it intrudes, it creates crosses right now have difficulty get crushed by growth.

That's why at the times of uncertainties, declining interest rates, even sometimes dividend yielding stocks don't do well. And so the reason for that is there are cross currents. If we stay with one system, it's pretty clear what to do. If we move to another system, it's pretty clear what to do. if we're staying in between in return back to growth, and therefore, local authorities will simply pull back and everything returns back to normal. To me, the probability of that occurring is close to zero. So I have one more question for you, and it's sort of a step-back question on everything we've been discussing. But, you know, if you read your research, it feels like a lot of the problems that you identify with the current system

are that we are over-indebted, and we're not going to be able to reflate our way out of that debt using existing monetary methods. And yet, you're also advocating for fiscal stimulus in the form of MMT or neocanesism. And I think, you know, that's the policy that basically says, don't worry about the deficit. So how do you square those two ideas? Can indebtedness be both the problem and the solution? That's exactly what it is. But the most, I guess, basic principle is returning back to normality

is not on the cause. So we need to choose our poison. For the last 30, 40 years, the West was taking one poison. It's called monetary. It indirectly tries to influence the behavior of private sector. The fact of that policy

for the last 10, 15 years is becoming so toxic that neither people nor political classes, nor anybody else is prepared to just carry on with it. The other poison we have is what we have discussed. It doesn't necessarily solve the problem. We're not returning back to equilibrium, whatever that equilibrium is. We're not returning back to the normality. But instead, we're taking another poison that has less. Because remember, only China practiced all three. They know the side effects of the other two. We in the West have not really used the other two poisons since 1950s, so nobody really remembers. So from my point of view, what New Canes and MMT does, they give us another way of keeping society intact,

keeping economies intact, with a lower degree of side effects, lowering the pressure, not dissimilar to what Ireland Chancellor Bismarck did in Germany in 1880s by introducing welfare benefits, That reduced some of the pressure that arose out of industrial revolutions. We need to do something similar to reduce the pressure on societies. It doesn't solve the problem. I'm not suggesting it solves a problem. All it does, it provides another drug to keep going with the lower side effects and reducing some of the geopolitical and social pressures that we are experiencing.

In the next several decades, a different world will emerge. it's going to be something completely different. I don't know believe it's going to be a conventional capitalism. But we need to go through decades to get there. And so I think we need to switch the draw. That's Victor Schwetz. The only cell-side analyst I know who can reference Bismarck on a podcast and quote marks in his research. Thank you so much for being on Oddlots. Thank you. Thank you, Tracy. So this has been another episode of the Oddlots podcast. You can follow me on Twitter at Tracy Allaway.

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