When yields on assets everywhere have been pushed down to nil, investors are left with strange choices.
And the ones they’re making could yet cause serious disruptions.
Central banks, led by the U.S. Federal Reserve, cut official short-term interest rates to zero in an effort to ignite growth following the credit crunch. When that didn’t work, they started a program of quantitative easing, which entailed pushing down yields across the interest rate curve.
Near zero yields on government debt then pushed down yields across other assets: equities, corporate debt, emerging markets. The result is that the trade-off between risk and return has broken down (though some commentators like Eric Falkenstein argue there never really was a relationship).
True, assets where there’s a very good likelihood you won’t get paid back still offer substantial yields, such as Venezuelan or Greek sovereign bonds, or the debt of companies in administration.
But as for the rest, the yield differentiation is negligible.
So what is the marginal investor, faced with a variety of assets that offer no yield, going to choose?
If short-dated Treasury bills are yielding the same as medium-term corporate debt or government paper with maturities of 10 years or more, it becomes hard to argue against holding cash. After all, the upside on longer-dated bonds is minimal but the downside is significant. This is a point Bill Gross at the bond fund Pimco recently made.
What about real assets like commodities or equities rather than nominal ones like bonds?
Commodities have certainly performed very well lately, especially those seen as hedges against inflation like gold and silver. They yield more or less the same as cash yet have the potential for unlimited capital gains in a world where central banks are debasing currencies.
But at some point, and I think this point has been reached, the valuation put on these assets will preclude the central bank from imposing a regime of price stability. It may be reasonable to assume the Fed and other central banks will allow inflation to reach 5% or 6% for a time, but is it rational to believe that it will not react if inflation runs to double digits? I don’t think so. And yet, I think the price of gold, in particular, indicates investors expect very high inflation rates.
As for equities, surely they are a good hedge against a world of 5% or 6% inflation? Yes. But bear in mind investors have come to realize that 50% moves in equity prices are not uncommon. Having suffered two 50% drops in the value of these assets during the past decade, investors have lost confidence in shares. And yields of between 2% and 3% are little compensation for these sorts of massive swings....MORE