A prominent economist is warning that for future retirees, the funds they're expecting – pensions, life insurance policies, even market money funds – may not be there when they need it most.
It's important for Canadians to note that Citi chief economist Willem Buiter's terrifying Monday report, How Many Financial Sector Business Models Are Damaged By Low and Negative Rates, was written with a focus on the European market, where government bond yields are becoming more negative by the day. This is not (yet) the case in Canada. As the chart below shows, the domestic five-year bond yield is 0.59 per cent while the yield on five-year German government bonds is now minus-0.50 per cent.
Mr. Buiter's warnings concerning Europe, however, are so dire and immediate that Canadians must take note in the case the domestic economic recovery stalls and we eventually find ourselves in a similar pickle to the Europeans.
Among the more startling conclusions is that money-market funds with a fixed net asset value of $1, $5 or $10 are not possible in a negative-rate environment.
Money-market funds are not just a convenient place for investors to store cash. They are also vital for credit markets as a primary source of demand for short-term bank debt, packaged auto loans and mortgages, funding for corporate receivables and short-term corporate debt issues used for liquidity and payroll purposes.
"[C]onstant net asset value money market funds [those where the unit price doesn't change from, for example, $5] are not viable in a negative interest rate," Mr. Buiter writes. "That is incompatible with investing in risk-free assets yielding a negative rate of return."
In other words, a money-market fund with a constant unit price of $5 can't maintain the price if the investments its portfolio managers are buying for the fund have a negative yield. The value of the money-market fund will decline unless the managers ramp up portfolio risk. This confronts investors with the potential for losses from a wide variety of risks – poor business execution or bankruptcies for example – rather than just interest rate-related loss of principal.
In Europe, the risk to government pension funds is far worse and near-term than many believe. Mr. Buiter quotes the chief executive of France's largest public pension fund as predicting that if interest rates and dividends remain where they are, "many pension funds in Europe will implode over the next two to three years."
For banks and life insurance companies, Mr. Buiter finds the outlook less dim but still fraught with risk. He notes that for banks, profitability is based on the difference between the short-term rates they borrow at, and the long-term rates at which they loan funds to clients. The primary problem the banks will have is dropping deposit rates into negative territory in order to maintain any semblance of earnings growth. This would be, to say the least, highly unpopular.
The Citi economist is hopeful that well-managed insurance companies can compensate for low portfolio returns by diversifying into different financial businesses, and divert the profits to pay policyholder obligations. Those unable to do so will need what Mr. Buiter calls "a backstop Santa" – government or other body to make up the shortfall. In Canada, this would likely be the taxpayer.
Canadians can fervently hope that economic growth accelerates and we never have to deal with a negative interest-rate environment where even money market funds aren't safe. As it is, with current low interest rates it's difficult to foresee an environment without numerous smaller defined-benefit pension plans failing to make good on their promises. A further significant decline in interest rates and bond yields would make matters worse, threatening money-market investors and life insurance policyholders.
Scott Barlow, Globe Investor's in-house market strategist, writes exclusively for our subscribers at Inside the Market.