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Opus News & Insights

Black Hole
Friday, August 26, 2016

Recently, the Wall Street Journal published an article titled Black Hole of Negative Rates Is Dragging Down Yields Everywhere. The point the WSJ was making related to negative rates in developed sovereign bonds forcing rates lower in riskier areas, much like a voracious black hole consumes everything around it.

A more interesting analogy, in our opinion, relates to how assets are valued. The black hole is a freak of nature. At its center is a singularity, a point with infinite mass and infinite gravity at which space and time collapse on one another. American physicist Kip Thorne describes the singularity as "the point where all laws of physics break down".

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Just as the singularity breaks the laws of physics, negative rates break the laws of financial mathematics. Per this graph from Ned Davis Research, a $5 perpetuity is worth a little over $60 billion at a discount rate of -2%; by comparison, at a 1% discount rate, it is worth $500. Even a $5 perpetuity shrinking at 1% per year is worth over $6 million at -2%! Essentially, the value of assets ceases to be anchored by mathematical calculations, but rather solely by sentiment, as rates approach zero and become negative. One can imagine no other reason an investor would buy a bond with a negative rate, other than assuming they can sell it at a higher price in the future to a greater fool.

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At least this makes investing easier for those who are not great at math, like former President Gerald Ford. For those paying attention, however, negative rates were something only banks and large institutions had to worry about. Even Super Mario himself said the move to negative rates was “for the banks, not the people.” So the ECB kept chopping rates to encourage spending:

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Unfortunately, savers woke up to a different world when a small Bavarianbank decided to pass along negative rates to savers with balances greater than 100,000 euros. The bank’s board, a first mover in what amounts to a tax on individual savings, stated “With our business clients there’s been a negative rate for quite some time, so why should it be any different for private individuals with big balances?” What’s a saver to do? You could start stuffing that mattress or hope that, like black holes break the law of physics, your savings break free of the law of financial mathematics. I’ve got $5 on it.

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