For those of us who have been calling a bottom and predicting a rally, Friday was finally the day. After watching the market sputter for most of January, the month closed with a bang.
The Dow soared 397 points, and the S&P 500 (NYSEARCA:SPY) was up more than two percent. Despite the huge gains, the S&P was still down 5% for the month, getting the year off to quite the poor start.
What saved the month from closing in even worse shape? Japan was the decisive actor.
Their central bank unexpectedly went negative, cutting rates beyond zero. Once thought of a curious European experiment, negative interest rates are now gaining credibility (in some circles) as a legitimate policy tool and not just as some sort of bizarre emergency move.
This move came as a stunning reversal to expectations. Japan's central banker had ruled out negative interest rates earlier in January. Just days later, the markets were shocked by the reversal.
International markets let out a huge sigh of relief, with just about everything (other than biotech) getting a massive pop. To give but one example, battered Brazil (NYSEARCA:EWZ) was up a stunning 7% on the day. To give another example, my Bancolombia (NYSE:CIB) is, incredibly enough, up more than 10% year-to-date now. Any signs of monetary easing will be met with great enthusiasm in emerging markets.
One-Day Wonder, Or Sustainable Move?
Many are quick to call Japan's move an act of desperation, and that the rally will quickly fade. I agree to the extent that Japan is in a corner and is unleashing increasingly erratic policy to try to get out of hardening quicksand.
However, I disagree that because this is arguably a desperate measure taken in desperate times, that it will immediately fail. What you've been seeing is a standoff between the Fed and the rest of the world.
The Fed is concerned about the mirage of inflation and the (allegedly) strengthening US economy. The rest of the world, largely, sees collapsing exports, tattered currencies, and credit markets freezing over. The US keeps resolutely pushing toward tighter money, sending the dollar ever higher, while the rest of the world faces ever-weakening economic conditions.
Now Japan has decisively thrown their lot in with Europe. The world needs easier money, they're saying. Perhaps forced to move with China weakening and devaluing, Japan felt pushed to keep the Yen in check. The Yen had been moving higher steadily until this latest maneuver, hitting new 52-week highs earlier in January.
Combine with the horrendous 0.7% US GDP growth for the fourth quarter, and you have a Fed that simply can't hike now, as much as they seem to want to. The rest of the world is easing even past zero, the US economy is suddenly and rapidly slowing, while inflation remains dormant. The case for hiking rates - as flimsy as it was - is totally gone now. The only remaining reasons for hiking; policy normalization, helping savers, ending the state of crisis - are non-economic in nature and are rooted in ethics and a sense of morality rather than any pragmatic reason.
The window for 3-4 Fed hikes this year is firmly shut. I'll be surprised if they get even one more off. Futures markets are showing a significant chance of the Fed cutting in 2017. Much of the selloff and uncertainty was coming from the Fed being hawkish for no apparent reason. Japan's move and the particularly weak GDP number almost compel the Fed to stand down. Stocks can - should - rally on that.
Are Negative Interests Rates Wrong?
A lot of us, myself included, initially rebelled at the thought of negative interest rates. It sounds like a kind of crazy idea. It certainly runs contrary to how the financial system has always worked. Particularly for savers, it seems like a raw deal.
But, is there another way of looking at it? First, let's ask ourselves, what is interest in a purely economic sense?
Interest is the cost of capital. If you need money and don't have it right now, interest is the rate you pay to use somebody else's capital. In a rapidly growing economy, demand for money is usually high, leading to significantly positive nominal interest rates.
But what happens if demand for money is very low? And supply of money is very high? When people have plenty of money reserves, as the banks do now, and there are few people or investments asking for or worthy of credit, then what? If the supply of money greatly exceeds the demand for money, why shouldn't the rate of interest be zero? Theoretically, there doesn't seem to be an inherent argument against zero.
Negative is trickier, in that it actually works as a form of confiscation from savers to debtors. This is certainly out of the norm. To the extent that negative interest rates are applied to banks and very large investors, it seems like a defensible policy tool to try to stabilize the velocity of money, which in the US anyway has been plunging.
Where it takes on more ominous overtones is the idea of negative interest rates on small accounts such as ordinary checking and savings accounts. The obvious flaw is that people can take their money out of the bank - where they have to pay to store it - and move it elsewhere and avoid the negative rate. The logical next step would be the elimination of paper money. By digitizing, the government and banking system can compel financial participants to spend, invest is riskier ventures, or see their savings taxed with negative rates. The potential big government/government gone amok implications of a no-cash society are significant and troubling.
From a more practical standpoint, negative interest rates might trigger some unwanted side effects, such as people hoarding gold (NYSEARCA:GLD), silver (NYSEARCA:SLV), other such goods, and moving more of the economy into the black market to avoid the financial controls. The long-term implications of introducing this inefficiency into the economy might well outweigh the potential benefits of negative interest rates in stimulating the economy.
Going back to the original question though, can negative interest rates be justified? I'd argue tentatively, that yes, they might be. My hypothesis comes from demographics. Japan faces a rapidly aging population. Lacking nearly enough children and being dead set against immigration, Japan faces a dramatic population decline over the next 50 years.
Barring some sort of technological breakthrough that dramatically boosts worker productivity, Japan's economy will shrink by large amounts for decades. Forget about 0, merely keeping the economy from shrinking too quickly will be the goal.
How will companies react? They will stop investing in new capital goods in Japan. Money will flee the country or further pile up in savings accounts. A dramatic long-term deflation in Japanese prices is likely, barring outright government printing of vast amounts of new money.
The notion of nominal vs. real interest rates is important. Nominal is the rate the bank quotes, real is what you get after adjusting for inflation (or deflation). If the bank is paying you 7% and the inflation rate is 10%, you're losing 3% a year. 7% sounds great in abstract, but it all depends on the inflation rate. You'd be better off with a nominal interest rate of 3% and an inflation rate of 2%, since your actual purchasing power rises at 1% a year.
In a world with persistent deflation, as is increasingly probable in Japan and Europe, a 0% nominal interest rate might be a good rate indeed. If prices deflate at 3% a year and you get 0% parking it at the bank, you're making 3% a year (and not paying any tax on interest to boot!). You could argue even a -1% nominal interest rate isn't bad in a world where prices drop 3% a year.
You might be saying, but Ian, that's crazy, prices never go down. Ask your grandparents if you're young, many of them still remember deflation. It's possible, even in a world with central banks. It's been centuries since the Western world faced the specter of steadily decreasing populations.
While there is hardly a counterfactual with which to compare, there's a certain logic to the idea that steadily increasing populations inherently drive inflationary pressure, while steadily decreasing populations would induce deflation. Certainly in commodity goods, falling populations should drive steadily falling prices.
The world's economy is heading into uncharted waters. The future - outside of certain emerging markets - looks increasingly dim as far as growth goes. There's no reason to think money demand aka interest rates have to shoot back up anytime soon. As long as populations are dropping and consumer demand is soft, companies will invest very little in new factories and machine goods. They'll keep buying back stock and otherwise engaging in financial maneuvers, lacking any better use of capital. Negative interest rates may become a standard part of the landscape to address the shifting environment.
Green Light For More Rally: Don't Fear The Rate Cut
Now that the worst of the storm has passed, it's a good time to reflect back on the past month. The permabears, as they usually do, made really compelling arguments for why we were already in a bear market and that this correction was going a lot lower.
They had wonderful charts, compelling images, and reasonable-sounding theories. But again, it didn't play out. The big warning was how quickly everyone became convinced this was the big new bear market everyone was waiting for.
Remember that chart I posted when the market was down 10% and Google searches for "bear market" were way above their peak in 2011, when Europe was collapsing and the S&P was already down 19%? Big selloffs come when everyone is long, excited and avarice hangs palpably in the air. When people are already cowering on the sidelines there are far fewer "weak hands" to shake out in a selloff.
A few of the bears I'd been reading are already out this weekend with the usual, we can't believe Japan is doing this rhetoric. They say that Japan got into this mess with QE and unusual economic policies, and this is more of the same failed drug. That may be true (though I'd argue demographics are the real root cause of that country's problems, along with their strident opposition to all immigration).
As the bears are prone to do, they're now saying that absent central bank manipulation, they would have been right. We've been hearing that refrain since 2009, and you know, it's probably true. But you and I do live in a world with central bank manipulation. We live in a world where most people - including voters - want stocks to go up. When possible, politicians will do what they can to keep stocks from crashing.
So when stocks are already down pretty big, like they were in mid-January, you should expect the government to do something to shore up markets. If you're betting on a market already down 12% to plunge more, you're betting that there won't be a dead cat bounce, that there won't be serious buyers interested in getting in at cheaper prices, and you're betting the government won't do something out of the blue to prop up prices. It's a tough trade. There are so many different ways to lose!
Barring some sort of 2008-style total financial trainwreck, it's hard to stay short markets after they already drop big. The deck is so stacked against short sellers that you have to be really really right to make money at it. I short individual stocks aggressively, but the market as a whole is tough, particularly in bull markets. When bearish chatter reaches a crescendo, there's almost always a good buying opportunity at hand.
Now, we're to the stage of the recovery where bears blame outside cosmic forces for ruining their trade. Bulls get little credit for buying near the bottom, since we of course "got lucky" or "bailed out" by a "desperate" Japanese government. Remember, bears almost always sound smarter than bulls and have better arguments. Negativity usually seems more reasonable than unbridled optimism. And yet those optimists usually end up with more money. Where's the Warren Buffett of perma-short sellers that's made billions betting against America?
None of this is to promote blind optimism on the market. I'm quite skeptical of the global economic outlook for 2016. I expect US stocks to break the 1,800 level on SPX at some point in the next 12-18 months, if not sooner. But don't put me in the bear market camp quite yet.
I reiterate my call for new highs on the market first. New QE announcements usually lead to rallies. Remember any of those Zerohedge charts that show basically all the gains in this bull market came following central bank action? Well, you just got big action from Japan, and you're about to see the global money easing + Fed stop hiking rally.
I've said it before, but I want to repeat myself and make it very clear. If that selloff was enough to really spook you, use this upcoming rally to sell stuff! The bull market has been running for almost seven years now. If you're aggressively long at this point, you're being a pig. At some point, the market will dump 20-30%, and you'll regret being levered and long, holding low quality stocks. Already, anyone long biotech (NYSEARCA:XBI) is learning this painful lesson.
Disclosure: I am/we are long CIB.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Short EWZ.