Interest Rate Limbo - How Low Can They Go?

If interest rates on Government bonds was a limbo contest, the United States would be knocked out of the competition. Interest rates in the U.S. are at historic lows, but are still much higher than many of its overseas counterparts. For example, the yield on a 10-year U.S. Government bond is around 1.90%, whereas a German Government bond (Bund) is currently yielding 0.15%. Ironically, tumbling interest rates in Europe have put some banks in an inconceivable position: owing money on loans to borrowers.

As noted in the Wall Street Journal this week, at least one Spanish bank, Bankinter SA, the country’s seventh-largest lender by market value, has been paying some customers interest on mortgages by deducting that amount from the principal the borrower owes.

Banks set interest rates on many loans as a small percentage above or below a benchmark such as Euribor. As rates have declined, sometimes to below zero, some banks have faced the paradox of paying interest to those who have borrowed money from them. The vast majority of Spanish home mortgages have rates that rise and fall tied to 12-month Euribor, said Irene Peña, an economist with Spain’s mortgage association. That rate stands at 0.187%.

In Spain, Bankinter has been forced to deduct some clients’ mortgage principal payments because an interest-rate benchmark tied to Switzerland’s currency has dipped into negative territory. "I’m going to frame my bank statement, which shows that Bankinter is paying me interest on my mortgage,” said a customer who lives in Madrid. “That’s financial history.” Bankinter has few such mortgages tied to a negative Libor rate, a spokesman said, declining to provide a figure. 

Spain is not alone with this dilemma; Portugal’s central bank recently ruled that banks would have to pay interest on existing loans if Euribor plus any additional spread falls below zero. More than 90% of the 2.3 million mortgages outstanding in Portugal have variable rates linked to Euribor. 

The following chart illustrates how this situation may come about:

Payback Chart

Until last week, no country had ever sold 10-year bonds that give investors a yield below 0%. Well Switzerland sold 10-year bonds last week yielding -0.055% (i.e., investors are paying the Swiss government to hold their money for 10 years). Due to lower overseas interest rates, along with a strong U.S. dollar and a U.S. economy in better shape than most, investors from across the globe are buying U.S. bonds. In addition, U.S. corporate pension funds are seeking a return on their investments and have been buying bonds as well. As a matter of fact, the Wall Street Journal reported this week that U.S. corporate pension funds hold more of their assets in bonds versus stocks for the first time since 2002.  

If you combine all the factors previously listed with the fact that inflation is nowhere to be found, then it is a good bet that interest rates in the U.S. will remain quite tame for the near future and continue to be held down by lower overseas rates, which increases the demand for our bonds. Even though negative interest rates sound intriguing, and getting paid by the bank on money you owe them appears to be a slam dunk, I don't believe we'd want to trade economic conditions with those countries.

A Long, Cold Winter May Result in More Consumer Spending Later This Spring

Similar to what we saw in 2014, bitter cold and snowstorms across much of the eastern U.S. appear this year to have cut into spending, and some private economists are marking down their estimates for first-quarter growth. Consumer spending barely rose in February and spending on goods and services, when adjusted for inflation, actually declined slightly for the first time in 10 months.

“It does look like weather might have been a disruption in the first quarter, just like we thought a year ago,” said Laura Rosner, U.S. economist at BNP Paribas. We could have the same result as last year, in that consumers had a pent up demand to spend after a long and cold winter, which may result in a nice bounce in spending this spring. U.S. consumers normally don’t like to delay their spending gratification, and this could spell a nice rebound in corporate profits in the coming months, which will be good for stocks.

This Will Not End Well for Most Investors

The Wall Street Journal reported this week that housed in a skyscraper with a 160-foot-tall statue of a bull’s head out front is the world’s best-performing stock market this year, a $3 trillion exchange that is little known outside China. Shenzhen, a former fishing village that is now one of China’s most modern cities, is considered the birthplace of the country’s economic reforms three decades ago.

Shares on the Shenzhen Stock Exchange, one of the largest globally, have surged 55% this year, boosted by droves of small-scale investors furiously trading China’s hottest young companies. These businesses are seen as China’s future.

The Shenzhen market is driven by fast-trading mom-and-pop investors, who often buy and sell based on what they read in state-owned media, or hear from friends. Some simply jump into stocks that are already going up. Institutional investors, using the advice of professional stock analysts, are the minority, and market participants say insider trading is still problematic.

“I’m just dabbling. If all your friends are buying stocks and talking about it, and you don’t buy, then you have nothing to talk to them about,” said 32-year old Liu Wei, who works in real-estate management in Shenzhen.

He had been waiting in line for an hour to start a trading account at a branch of China Merchants Securities one April morning and planned to invest a few thousand yuan, equivalent to several hundred dollars.

A woman named Ms. Yu, who only gave her last name, said she had 1 million yuan (roughly $160,000) in stocks. Like Mr. Wei, she takes investing advice from friends. “Their recommendations have been good,” she said, allowing her to reap gains of 20% to 30%.

She said that the market goes through cycles, and investors alternate between exuberance when the market is in an upswing and more sober trading in normal periods. In 2007, the market fell 67% from its peak, only recovering those losses this February.

On Shenzhen’s board for small and medium enterprises, also set up after the main board, is Cloud Live Technology Group Co. Ltd., a former restaurant chain that transformed itself into a cloud-computing business when China’s corruption crackdown blocked bureaucrats from spending on its high-end Hunan cuisine. Last week, Cloud Live became the first company to default on the principal of its onshore debt.

For stock investors, the news didn’t seem to matter. Shares rose on the day of the default and are up 43% this year.

The founders of these businesses “believe in themselves and their stories,” Mr. Yao says. “That energy or passion is contagious to investors.”

Firms traded in Shenzhen range from software developers, pharmaceutical businesses, makers of parts for electronics and other technology names, to a bevy of consumer companies, from fashion and textiles to food and beverages. Beijing has been pushing businesses like these, hoping they can shoulder the role of powering the economy that long has fallen to lumbering, state-owned companies in heavy industry.

The Shenzhen market ranks fourth in Asia in capitalization after exchanges in Tokyo, Shanghai and Hong Kong, and eighth in the world, according to February data from the World Federation of Exchanges.

Chinese investors have moved back into stocks because banks pay low rates on deposits and the property market has stumbled.

“We’re doing it because it’s better than saving money in the bank,” said Ms. Li, a potential investor who only gave her last name. “I don’t know what stocks to pick. My friends just recommend them.”

I think it is exciting that Chinese citizens are able to invest their savings into stocks. Unfortunately, regulations in China are minimal and it appears that many of these investors are selecting stocks on a whim or friends’ advice. Sadly, this picture does not do well long-term. I believe the chances are exceedingly high that a good number of these investors will get burned in Enron-like scandals in the years to come.


"The hardest thing in the world to understand is income tax."

                        Albert Einstein

"You can be happy with money and you can be wretched with it. It depends on what kind of person you are."

                        Taylor Caldwell 

Quotes selected by the IAG staff

"Whenever the heat's on, my whole life, I've just kind of learned to focus a little more."

                         Jordan Spieth

"Money is only a tool.  It will take you wherever you wish, but it will not replace you as the driver."

                         Ayn Rand


Tony Moeller, CPA

The information listed in this commentary is a compilation of various publicly available sources and is for informational purposes only. It is not a recommendation or solicitation of any particular investment or strategy. A risk of loss is involved with investments in the stock and bond markets.

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