“It’s like learning to drive a car backwards.”
– Danish banker on navigating negative interest rates
We’re talking about the upside-down world of negative interest rates, a phenomenon that seems to bother nobody but me. As we saw in my last post, NIRP has important implications for banks, for borrowers, for calculating risk premia, and for future expected returns on stocks and other risk assets
But let’s continue our exploration of this Alice-in-Wonderland world by asking ourselves this question: what sort of nut-case investor would buy bonds that sport negative interest rates?(1) If you buy such a bond and hold it to maturity, you are guaranteed to lose money. Granted that there are a lot of nut-case investors out there (basically, all those folks who increased the risk profile of their portfolios over the past year or so), but buying an investment that’s guaranteed to lose money still seems a little, uh, eccentric.
But in February Germany sold US$4 billion of five-year notes at an average yield of -0.08%.(2) Somebody’s buying this stuff, but who? One possibility is buyers who more or less have to own high quality fixed income securities and hang the yield (or lack of it). Insurance companies, for example, must invest most of their surplus in bonds or risk the ire of both regulators and credit ratings agencies (like A.M. Best). But at least early in a NIRP cycle insurance companies can hold cash, which yields nothing but at least doesn’t (yet) yield less than nothing. Another possibility: banks in the Eurozone might find themselves with the choice of parking their cash at the ECB, where it would earn -0.2%, or buying the German notes at a sparkling -0.08%.(3)
But in fact, the folks who bought the German notes were likely mainly speculators who had no intention of holding the paper for five years – indeed, five weeks would have been a closer guess.
The German notes came out in February, and everybody knew that in March the ECB was going to start buying huge quantities of European bonds. As we’ll all recall from Fixed Income 101, when demand for bonds goes up, the price goes up and the yield goes down. Thus, it hardly matters what the yield was in February – positive, flat, or negative. All that matters is that, whatever it was, it was likely to get lower in the face of ECB buying pressure.
If notes are issued at -0.08% and subsequently the market yield drops to -0.10%, our hardy speculators have just made a mark-to-market profit. Not a big profit, to be sure, but when you annualize their five-week hold, and measure it against flat-to-negative inflation, that profit looks pretty good.
So, based on this brief example, we can infer that NIRP doesn’t necessarily harm short-term investors, although, of course, it does harm long-term investors – those poor folks who bought the German notes and planned to hold them to maturity. In a normal world, short-term investors face huge headwinds, but in a NIRP world it’s the patient, long-term investors who are penalized.
Also in this upside-down, inside-out world, central bankers find themselves peculiarly impotent. In a normal recession, central bankers reduce short-term interest rates to encourage people to borrow and thus stimulate the economy. In fact, the Fed has dropped interest rates an average of 3.9% in the past to deal with recessions. But if rates are already at 0%, is the Fed going to push them down to -4% No, in the world of QE-NIRP, since rates are already very low, the central bankers, not wanting there to be any pressure on politicians to do something, engage in unconventional policies like QE. The idea is to create demand, which will push up rates and inflation, in this case to the central bankers’ 2% target.
But hold on here! If a central banker goes out and buys gigantic quantities of bonds, that drives rates down, as we just recalled from Fixed Income 101. In fact, it will eventually drive interest rates negative. Back in 1968 a brain-dead US Army officer remarked that, “We had to destroy the village in order to save it.” Similarly, central bankers seem to have decided that they have to destroy interest rates in order to save them. “Maybe,” the bankers are thinking, “if we drive rates down below zero that will cause them to rise to 2%!” But magical thinking isn’t a game plan.
So maybe we should think about this. If people aren’t willing to borrow at 1% interest, what in the world makes anybody think they’ll borrow at 0% interest? Or, Lord help us, -1% interest?
People aren’t not borrowing because rates are too high – that’s preposterous. No, they’re not borrowing because what in the world would they do with the money they borrowed? The central bankers, by driving interest rates below zero, are telling us, if we didn’t already know, that there is absolutely no demand out there. In the face of that lack of demand, am I going to borrow money and expand my factory so I can produce more goods nobody wants? Am I going to hire hordes of people who will then have nothing to do? No, I’m going to sit on my cash until demand picks up, no matter what interest rates are.(4)
Which leads us to the nub of the matter: Why is demand so low? Once we know the answer to that question, we can ask the next one: Does Negative Interest Rate Policy have anything to do with the core problem?
We’ll get to those items in my next post.
(1) Note that nominally negative interest rates are quite common. If the central bankers are holding interest rates at 1% when inflation is at 2% – or holding rates at 5% when inflation is at 9% – the inflation-adjusted yield is negative. This is known as “financial repression.”
(2) Coupons are always positive, of course, but if a bond (or note) sells at a premium the resulting yield can be negative.
(3) Note, also, that some large depositors in US banks are already accepting negative rates, although this legerdemain hasn’t (yet) made it to retail customers. Dodd-Frank’s Transaction Account Guarantee program insures non-interest-bearing demand deposits without limit. However, banks charge these customers the cost of FDIC Insurance because the banks have no use for the funds. The depositor, meanwhile, is just happy to have the FDIC guarantee.
(4) As noted in my last post, US companies alone are sitting on $5 trillion of cash.
Next up: On NIRP (Part 3)
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