Howard Marks, Negative Rates And The Permanent State Of Exception

In his latest memo, dated October 17, Oaktree’s Howard Marks tried something different.

Rather than delivering a series of musings centered around current events and general goings-on across capital markets, Marks endeavored to grant a request. As he writes in the introduction,  Ian Schapiro, the leader of Oaktree’s Power Opportunities, asked Howard to weigh in on negative rates.

Howard says his initial response was “immediate and unequivocal”. To wit: “I can’t.  I don’t know anything about them.” 

Then, he realized that was precisely the point – nobody does. We’re in experimental territory, but it’s probably time that whatever wisdom we’ve accumulated over the past decade gets codified or otherwise organized into a coherent exposition, because it’s abundantly clear that there is no turning back.

We’ve persisted for so long in the post-crisis monetary policy experiment that the “extraordinary” has become quite ordinary, indeed. Perversions like negative rates and the “bad news is good news” phenomenon, are becoming fixtures of the market. The “state of exception” has become “permanent”, to quote Deutsche Bank’s Aleksandar Kocic.

As we wrote back in July, if this goes on for another five years, they’re going to have to start amending the entry-level finance textbooks to include a series of caveats, footnotes and disclaimers, or else divide things into two sections – “the way things used to be” versus the way things are now; pre-crisis versus post-crisis, B.C. and Anno Domini.

To a certain extent, Marks’s memo on negative rates reflects his contention that he “doesn’t know anything about them” and reads like what he admits it is: Essentially a summary of the “clippings on the subject” he’s been “saving up”.

But we wanted to highlight a couple of passages which speak to several discussions we’ve had in these pages over the past year.

In the course of listing the ways negative rates act to “turn a lot of the usual processes upside down”, Marks mentions negative-yielding corporate bonds.

“How will the markets value businesses that hold cash versus those that are deep in debt?”, Howard wonders, noting that “traditionally, markets have penalized heavily levered companies and rewarded those that are cash-rich”.

But how does that change when negative rates effectively convert liabilities into assets? “If having negative-yield debt outstanding becomes a source of income, will levered companies be considered more creditworthy?”, Marks goes on to ask.

Remember, negative-yielding corporate debt isn’t so “anomalous” anymore – at least not across the pond. This isn’t idle speculation around some quaint curiosity. At one point in late August, when yields plunged across the globe, some €1.1 trillion of European corporate bonds sported yields less than zero. That, BofA marveled, is half of the entire € IG corporate credit market.

(BofA)

As BofA wrote at the time, “there are now 100 different issuers in the Euro-denominated credit market that have all of their corporate bonds yielding below zero”. Let that sink in. As of the last week in August, there were 100 companies in the € debt market whose entire curve was negative. (And don’t forget about negative-yielding “high” yield debt, the ultimate oxymoron).

In a sense, debt has become an asset for those corporates. Clearly, that would tend to incentivize issuance. Those companies can essentially mint assets.

“The risk is that companies begin to view negative yielding debt more as an ‘asset’ going forward, rather than a ‘liability’ and hence issue more of it”, BofA’s Barnaby Martin said, in a kind of pseudo-lament.

Now, think about the flip side of that. Marks poses it as a question: “Conversely, how will the market value businesses that hold a lot of cash and thus have to pay banks to keep it on deposit?” That cash is a liability one way or another in a negative rates regime where large deposits aren’t spared – either the cash “earns” a negative yield on deposit, or you pay to store it somewhere, which is, in effect, the same thing (the cost of storage is essentially a tax).

Later, while discussing whether negative rates will ultimately make landfall in the US, Howard says that in his estimation, stronger current economic growth and better growth prospects obviate the need for “emergency measures” (like negative rates), while higher inflation expectations (he mentions the tightness of the labor supply), less pessimism and better opportunities for deploying long-term capital, all argue against the adoption of negative rates in the US.

Still he admits that’s just an opinion. “When you express an opinion, the real question is whether you’ll bet on it and whether you’ll give odds”, he writes, adding that he “might put up $60 to win $50 from you if negative rates don’t materialize [b]ut that’s not a sign of much confidence on my part”.

After some additional musings, Marks makes a crucial point that we’ve discussed here on at least a half-dozen occasions since August.

“Negative rates abroad strengthen demand for dollars so foreigners can invest at the positive US yields, causing the dollar to appreciate”, he says, before neatly summarizing the implications of that for imported disinflation.  To wit:

Thus the Fed may have to lower rates to keep the foreign-currency cost of US exports from rising too much, and thus their competitiveness from declining and our economy from weakening.  How long can the Fed maintain rates that are much higher than those in the rest of the world?

That is a short version of a longer thesis advanced by Deutsche Bank’s Stuart Sparks in September. Essentially, Sparks argues that market pricing for aggressive Fed cuts reflected not necessarily recession fears, but rather traders pricing in an eventual capitulation from a Fed that fears imported disinflation (more on that here and here).

“Maybe I should reconsider my offer of 6-to-5 in favor of rates staying positive”, Marks quips.

The last bit we would highlight, is Howard’s warning (if that’s the right word) around what the application of negative rates to small savers would mean for the semi-global populist uprising that’s swept across western democracies. “If interest rates for small savers ever were to go negative, it would give rise to the juxtaposition of income penalties for households with benefits for ‘the elites’ through their ability to profit from rising equity prices”, he says, adding that “economic impact aside, the boost to populist politics would likely be dramatic”. Of course, that assumes monetary policy isn’t paired with fiscal policy in MMT fashion with the goal of delivering a kind of “QE for the people”.

In any event, you can read Howard’s full memo here.  One of the many conclusions he offers is that “Whatever we knew in the past about how things worked, I think we know less when rates are negative”.

That’s for sure. And, as alluded to above, it’s probably time everyone starts to come to terms with the reality of negative rates, as they are perhaps the defining feature of a “state of exception” which is on the cusp of becoming less “exception” and more “rule”

With that, we’ll leave you with the following two classic passages from Deutsche’s Kocic.

In its core, policy response to the crises was an extension of what in a political context is known as the state of exception: Market laws had to be suspended to restore normal functioning of the markets. The intrinsic contradiction of this maneuver is resolved only by understanding that suspension is temporary. Stimulus will have to be unwound. However, the accommodation has been in place for a very long time, during which traditional transmission mechanisms have atrophied and investors’ mindset has changed in a way that has altered irreversibly their behavior, the market functioning and its dynamics.

Engineering a state of exception comes with considerable risk. The Fed (and central banks in general) carries an implicit responsibility for orderly reemancipation of the markets, which makes stimulus unwind especially tricky. This highlights the deep dichotomy of power: While a state of exception is an exercise of power, there is a clear tendency to disown that power. And the only way to avoid facing the underlying dilemma is to never give up the power. This creates a new status quo – a permanent state of exception.

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