Cash, it would seem, has gone out of fashion, judging by the low and even negative yields at which people have been willing to give it up.
In Canada and the U.S., investors are parting with their money for government bonds at low single-digit coupons that make negative short-term real returns almost certain. In Germany, the Netherlands and France, new government bonds are being issued and bought at more than redemption value. This is giving up liquidity – and paying to do so.
One rationale for taking crumbs of interest, or even paying to park money, has been the prospect that deflation could grow and spread. Such an event would give government bonds and their interest payments more purchasing power as price levels decline. What will bring back liquidity will be the declining flow of funds into capital markets. Money, in short, will become more scarce and command a higher premium in the form of yields. The transformation back to historical norms for parting with cash is already baked into demographic trends. It’s a slow process, but nonetheless inevitable.
The liquidity problem now is that there simply is too much of it. Central banks have flooded financial markets with cash through bond-buying programs. Quantitative easing has vastly increased the money supply and the price of money expressed in the yield curve has plummeted. In time, that will change.
What will cause the change will be retirees spending their savings, shifting cash out of capital markets and into retail goods, real estate in Florida, etc. Safety at any price in government bonds giving negative real yield will fade as the price of money on the yield curve – giving up liquidity for specified time frames – normalizes.
Economists Charles A.E. Goodhart and Philipp Erfurth note in a study published on the online portal of the Centre For Economic Policy Research (www.VoxEU.org) on Nov. 4, 2014, that the ratio of workers to retirees is plunging in developed countries and soon will decrease in many emerging markets. Retirees’ savings will be eaten up through spending. In turn, loanable funds will change from a flood to a relative trickle. This, the study’s authors predict, will drag real interest rates back to the historical equilibrium of 2.5%-3% by 2025, with nominal rates at 4.5%-5%.
And hiring money for longer periods also will cost more. That means a steepening of the yield curve, says Chris Kresic, senior partner and head of fixed-income with Jarislowsky Fraser Ltd. in Toronto: “The current situation of ultra-low [interest] rates arose when central bank bond buying reduced interest rates and pushed people into less liquid assets such as stocks.”
In the end, older consumers will decide the balance of saving vs spending in favour of more spending. In turn, liquidity will command a higher price in the form of increased interest rates. Generational dissaving is a characteristic of retirement, just as asset accumulation and saving are characteristic of middle-age years after a client’s house is paid for and the kids have left home.
“With low interest rates and longer retirements, you need more savings to produce income equivalent to what was required decades ago,” Kresic says, “before the process of aging, retirement postponement and interest decline were so evident.”
For now, older people have to save more to maintain future income. When interest rates rise, saving for retirement or other things will require less fixed-income capital. That will allow people and institutions to spend more and save less, he explains.
Abandonment of very low and negative real and nominal yields will be slow. As James Hymas, president of Hymas Investment Management Inc. in Toronto, notes: “The yield curve does not work on demographic forces alone. The fabled 1% won’t just start spending on their 65th birthdays.”
At first, he argues, spending by people older than 65 will be a trickle, not a gusher. That is all the more reason that interest rates will have to rise to generate savings, says Jack Ablin, executive vice president and chief investment officer with BMO Harris Private Bank in Chicago: “The natural and prudent thing is for savers to shorten [investment] terms as they age.”
After all, a 30-year maturity for a bond is reasonable for a person at age 40; speculative for a person at 60, who wants the assurance of return of capital; and dubious for a person at 80, who wants the assurance of cash reversion that actual bonds – but not bond funds – provide. The perception of mortality will make borrowing money for longer periods more costly. Thus, the term premium that buyers demand for taking on longer obligations will rise.
Although 2025 is a decade away and 2050 is beyond advisors’ planning horizon for all but clients younger than 50 years of age, there are processes underway that will push up the liquidity preferences of workers and savers.
“Aging inevitably raises the liquidity preferences of older people who are converting their assets to cash and raises the premiums that [investors] will want for taking on longer obligations,” says Graeme Egan, financial planner and portfolio manager with KCM Wealth Management Inc. in Vancouver. “When economic growth increases, it will reduce excess capacity, banish deflation fears and increase demand for loanable funds. Interest rates will rise. That’s when giving up cash for a time to the bond market or parking it in a bank will start to pay. That will be the return to the old normal.”
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