“There is no barrier for US Treasury yields going below zero. Zero has no meaning, besides being a certain level”
-Alan Greenspan (Aug. 2019)
“You’re seeing it pretty much throughout the world. It’s only a matter of time before it’s more in the United States”
-Former Fed Chair, Alan Greenspan
(Sept. 4th, 2019 on CNBC)
Since the Great Recession of 2008-09, a large number of advanced economies have been stuck with low growth, low levels of investment and low inflation. Attempting to stimulate all three of those, central banks have been taking increasingly forceful monetary measures. Of these, perhaps the most controversial (and dangerous), and least understood, is Negative Interest Rates Policy (NIRP).
For the first time in six years, no central bank on Earth is hiking. Roughly half of them hiked at least once in 2018, and all of those have reversed course. So ten years into a global “expansion”, the main policy response has been “easing” interest rates:
USA: Easing
ECB: Easing
BOJ: Easing
BOE: Easing
China: Easing
Australia: Easing
Brazil: Easing
New Zealand: Easing
Russia: Easing
India: Easing
Korea: Easing
Indonesia: Easing
South Africa: Easing
I think everyone gets the point. In fact, the state of the global bond market is stark:
- Bond yields today are lower than at any time in the history of financial markets
- The entire yield curve for Germany, the Netherlands and Switzerland are below zero
- The Austrian 100 year bond now yields 0.8%
- Almost $15 Trillion dollars or 27% of all secondary bonds on the planet, yield <0%
- USA bonds now represent 80% of all positive yielding bonds, and are the only country with an “integer” in front of its bond yields
- Greek 10 year bonds and US 10 year treasuries yield approx. the same. Yes, the Greece that went broke 5-6 years ago.
- US treasuries hit all-time lows in mid-August
To me, it’s an “Alice in Wonderland” world, where everything is upside down and doesn’t make sense:
- US unemployment is at all-time lows, yet interest rate yields are collapsing
- Central banks have stimulated aggressively for over 10 years, yet there is no inflation
- All that stimulation yet economic growth is stagnant or non-existent
Never before in the history of the planet have long term global sovereign yields behaved like this; is this time “different”?
There can be many catalysts that can be the cause of this phenomena:
- Historical high debt levels
- Aging Western demographics
- Production gains from technology, artificial intelligence, robots
- Increased savings rates (i.e. higher demand)
- Decreased borrowing (i.e. lower demand)
- Deflation pressures overtaking inflationary pressures
- Poor central bank/government policies
But at the end of the day, whatever the root cause(s), the question remains: How low can interest rates go?
In practical terms, NIRP means commercial banks may deposit regulatory capital with their respective central bank, and get less for it than they might if they invested the money in the open market and paid a tiny premium – i.e. reverse interest from the central bank. This encompasses the idea of one paying back a little less than one owes and then “less less” if you will, becomes more, thus the logic of NIRP.
Rate cuts drive money out of countries and pushes their currencies lower. Thus making their exports more attractive. But if all countries cut rates and had a “race to the bottom”, if you will, wouldn’t the effects of those rat cuts logically cancel each other out? Exactly… and that might explain why Eurozone and Japanese economies remain stagnant.
The central bank of Denmark was the first to go below zero this cycle, in 2012. In 2014, several of Europe’s central banks followed suit. In 2016, so did the Bank of Japan (BOJ).
Cash has technically always had a zero interest rate, and over the years, economists have hatched many of an idea to make it less attractive. In the 19th Century, Silvio Gesell proposed a tax on holding cash. In 2009, Greg Mankiw proposed a lottery scheme for randomly picking serial numbers on bank notes and declaring them void, thus making it risky to hold cash. In 2014, Ken Rogoff proposed phasing out cash altogether, so there would be no alternative to paying a negative rate on bank deposits and bonds.
Ultimately, the aim of the central banks is to increase economic activity and spur inflation over deflation:
- Banks could lend more to households and corporations, rather than hold cash
- Businesses can invest more, as capital costs become cheaper
- Households could save less, borrow or spend more
- Demand for currency would fall, leading to a cheaper currency, which in turn leads to an increase in exports and an increased cost to imports (nationalism)
And if the western world has aging demographics, what happens to savers and retired people who live off their pensions because they have fixed savings or because they live off the interest from their investment capital?
So as I see it, looking at Europe, which is now seven years into this experiment, here are the potential outcomes for Euro bonds:
- If you buy a bond and hold it to maturity, you are guaranteed a small loss.
- If interest rates rise, you are guaranteed a big loss
- If things get worse (i.e. a recession), there is risk of a complete loss from rising defaults
Negative interest rates:
- Are terrible for banks, as they destroy the business model for banks which has been in place for thousands of years – profitability collapses
- Are bad for pension plans, savers, and seniors
- Are bad for the real economy that relies on the banks for the financial infrastructure so the economy can function (note 2008-09)
- Currencies collapse, which is good for exports, but really bad for any imports
- It reduces, not increases, credit creation
- It reduces liquidity in bond markets
- Central bank policy becomes futile
- Excessively lower rates tend to support asset prices, thus favouring rich over poor, further widening social gaps
While we have a long way to go before NIRP kicks in, it’s a good thing to think ahead and have a discussion. A steep and pro-longed recession, with deflationary risks, could do the trick. The track record for negative rates isn’t great. We don’t have to recreate the wheel here, one only has to look at Europe and Japan, the results have been mixed at best.
But it is no longer inconceivable or absurd to think that NIRP could happen in North America. For many years now, I’ve often said that when everyone believes something, it is usually wrong and the opposite happens. What does everyone believe now? That negative yields are unsustainable.
From an investment standpoint what would it mean? I would guess North American bonds get some sort of trading rally on a NIRP move, investors would flock to higher quality dividend paying blue chip stocks, and cash would flow to equities in search of a risk-managed, balanced portfolio. On the other side, my brain wonders if lower rates will simply encourage an already over indebted Canadian consumer to leverage even more and live even larger?
In a world where Denmark now pays you for a mortgage, and where banks now charge cash balances, it seems to be madness to me. The line is something like “markets can remain irrational” for a long time. In the end, I can’t believe we go there given the impact it would have on the financial sector and over society, but if the situation arises where central banks get desperate and all other arrows in the quiver are used up, NIRP might be the last hope.
Postdate Comment:
While this article was being finalized, in Denmark, they announced the “old rule” said negative rates only applied to bank accounts over $1 million. They just lowered that amount to $100,000.
Stay Tuned,
Vito
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