Negative interest rates are unsustainable, and once investors decide to stop paying for the privilege of holding government debt, a banking crisis could result, says James Grant.

The founder of Grant's Interest Rate Observer was one of several speakers at the New York Society of Security Analysts' (NYSSA) Annual Benjamin Graham Conference to remark on the ramifications of unprecedented loose monetary policy.

Central banks are treading in uncharted waters. Sidney Homer and Richard Sylla, the authors of A History of Interest Rates, found no instance of negative rates in 5,000 years. Now there are $11.7 trillion invested in negative-yield sovereign debt, including $7.9 trillion in Japanese government bonds and over $1 trillion in both French and German sovereign debt.

Grant posed a tongue-in-cheek question: "If these are the first sub-zero interest rates in 5,000 years, is this not the worst economy since 3,000 BC?"

This is not a bad economy by most measures. Household wealth in the United States has grown steadily since the Great Recession. If these gains were the result of greater productivity, interest rates would not need to stay at historic lows. Grant says they are "a sign of someone's thumb on the currency." Negative rates are propping up risk assets. He critiqued US Federal Reserve chair Janet Yellen's touting of the bull market in equities as a sign of prosperity by alluding to Brexit voters.

"Asset prices have failed to pacify the world's unprofitable voters," Grant said.

Investors have fallen into the trap of thinking that the future will be like the past, Grant says. The period of falling yields and rising bond prices that began in 1981 is entering its 35th year. He noted that a 35-year bear market preceded this. Yet the yield curve for Swiss bonds is sub-zero for the next 30 years, thereby implying that investors expect negative rates to persist for a long time.

Another reason to think rates must begin to rise: Bonds with negative yields are worse investments than cash. That has always been the reason for zero lower bound in monetary policy. So far, investors have been willing to pay for the convenience and security of storing wealth in banks and bonds, but if yields become sharply negative, some savers will no longer be able to accept guaranteed compounded losses. Then, conventional wisdom says, they will hoard cash, which returns 0%.

David Fuller's view

Here is a link to James Grant’s assessment, posted on Seeking Alpha.  

The symmetry of a 35-year bull market for government bonds since 1981, following a 35-year bear trend, ought to be a wakeup call for bond investors.  However, one of the hardest investment decisions to make concerns when to sell a profitable position of many years duration, especially while it is still in form. 

Psychologically, a long winning streak creates overconfidence.  It also causes the holder to trust reassuring views for why the profitable trend should continue indefinitely, especially as many value investors and Cassandras will have turned bearish way too early.  Bubbles often inflate beyond rational expectations. 

The only rational reasons for holding, let alone adding to long positions in bonds yielding interest rates near or below zero, would be a belief that deflationary pressures will increase and that the underlying currency will outperform.  While this is theoretically possible, central banks are throwing billions in various currencies at their respective economies in a determined effort to produce GDP growth and moderate inflation. 

Will this work?  I suspect so but bond investors will cite Japan’s disinflation and deflation over two decades and counting.  Meanwhile, we continue to see some largely positive deflation from technological innovation, as I have discussed from time to time. 

As for bubbles in any market, investors and leveraged speculators are conditioned to hold on, especially if they have temporarily closed positions too soon, and had to pay higher prices to get back in.  They can use trailing stops but these have to be well positioned to be effective.  Consequently, most sell after the bubble has burst, when the fear of further profit erosion exceeds the fear of missing out on additional gains.  Getting out of a bursting bubble can be messy because many other people will be scrambling for the same exit narrowed by one-way traffic.  

Meanwhile, a useful chart to watch is the Merrill Lynch Treasury 10-Year Future Total Return Index.  It is a lagging indicator but could be very helpful if used correctly and many bond investors will not have access to it.  Some of you will hold other bonds but a break in uptrend consistency for US 10-year Total Returns will cast a large shadow over the global sector.

Watch for vertical upward acceleration which is climactic and justifies a tight trailing stop.  Once out, I would stay out.  If that acceleration does not occur, watch for a correction which is clearly larger and possibly faster than the three equal-sized setbacks in 2009, 4Q 2010/1Q 2011, and 2013.  That would provide clear evidence of significant stale bull selling pressure.  Here also, once out I would stay out.