The longer the music plays and the louder it gets, the more deafening is the silence that follows.

– Claudio Borio, Bank for International Settlements

No one reading this post has ever had to invest capital during a prolonged period of negative interest rates. That’s because the last time it happened in the US was during the Great Depression, and if you were old enough to be investing then you’d be over 100 now.

So we’re in uncharted territory. But the odd thing is, nobody seems to be worried about it. The stock market continues to go up, financial institutions continue to put out pieces predicting 50,000 on the Dow. Everybody’s fat, dumb and happy.

But since we’ve never been here before, maybe we should pause and think about what NIRP actually means.

The first thing we might notice is that, from the time the dismal science was invented(2) until roughly last month, economists asserted that negative interest rates couldn’t happen, or at least couldn’t persist for very long. The reason is that, if banks tried to charge people for taking their cash, people wouldn’t deposit their cash in banks, banks would fail, and so would the economy.(3)

But this seems to be wrong. No one knows why, exactly, but we can certainly speculate about it. Here are some of those speculations:

* There is really no alternative. If everybody kept his cash under his mattresses, armed robberies would skyrocket. Is it really smart to put your family at risk just to avoid a small charge for keeping your cash safe?

* There really is no alternative. Last time I looked, US corporations were holding something like $5 trillion in cash.(4) We could figure out how many one hundred dollar bills that would be, but we already know the answer: too many to keep under the corporate mattress.(5)

* There is the de minimis factor. If you look at the 1099-INT you get from the bank where you keep your checking account, you’ll find that the number on it isn’t large enough to take the family out to dinner. If, next year, the number goes from +$100 to -$100, so what?

* Who uses cash anymore? The last ten times I actually had to use cash were all associated with this question: “Dad, can I have some cash to go to Chipotle?” I could have given the kids a credit card, except that I’m not an idiot.

* You don’t even have to pay your bills with cash. What you do is, you pay all your bills online, charging the amount to your credit card. At the end of the month, you transfer just enough money to your checking account to cover the payment necessary to pay the credit card balance in full, avoiding interest charges. That way you are over your minimum balance for only a few days.

There are other strange things about NIRP. Negative interest rates are a kind of Alice in Wonderland phenomenon, a violation of the known laws of human intercourse. It’s as though Einstein woke up one morning and discovered that there are lots of particles that travel faster than light. If you were riding on one of those particles, the Great Man would think to himself, would time move backwards? Would we get younger, rather than older? Walk backwards, rather than forwards? Read books from back to front?

Similarly, odd as it seems for a bank to be charging you for the privilege of taking your cash, imagine NIRP in other situations: if LIBOR is -2%, do the banks actually pay their customers to borrow money from them? A former governor of the Bank of Japan(6) once remarked that extremely low interest rates create a “zombie” mentality in which people can no longer discriminate among individual assets. (This undoubtedly explains the popularity of index funds.) Negative rates make zombie investors look good by comparison, as misallocations of capital multiply like rabbits: vast over-investment in risk assets; compression of risk premia (see below); proliferating duration risk as investors reach further out on the maturity curve; a general mispricing of risk.

Or imagine the risk premia that must be associated with NIRP. A risk premium is simply the amount of extra expected return you’d want before you’d buy a riskier asset, rather than a less risky one. If a Microsoft bond is paying 5% you wouldn’t buy Microsoft stock if you expected the return to be 5%.

One way you figure out the expected return on an asset is to start with the return on cash and add risk premia for each asset as you go out the risk spectrum. But if the return on cash is negative, the numbers you get for riskier assets become laughable. An intelligent investor simply wouldn’t invest in a World According to NIRP, and I’d be out of business.

And yet, intelligent investors do invest in the World According to NIRP. We’ll take a look at that phenomenon, and continue to speculate about the implications of NIRP, in my next post.

(1) Negative Interest Rate Policy, the policy of every central bank in the developed world, although the US Fed is wavering.

(2) Blame for this catastrophe seems to belong to Adam Smith, but he’s been dead for more than 200 years and therefore can’t be taken out and horsewhipped.

(3) “During the 1930s and early 1940s U.S. Treasury bonds and notes had negative nominal yields as they approached maturity. But since an investor can always hold cash, this is impossible. Any bond must have a positive nominal yield.” Stephen G. Cecchetti, “The Case of the Negative Nominal Interest Rates: New Estimates of the Term Structure of Interest Rates During the Great Depression,” NBER Working Paper No. 2472, Issued December 1987.

(4) The Fed estimates the cash hoard at $1.7 trillion, but that counts only money the companies keep on deposit in the US. The $5 trillion is a global figure for US-based corporations.

(5) This reminds me of the time Andrew Carnegie sold Carnegie Steel to a group of investors led by J. P. Morgan and became the wealthiest man in the world. Carnegie was paid in bonds of the new company, and so many bonds were delivered to him that the floor under his bank vault was too weak to carry the load. A special vault with a reinforced floor had to be constructed at the Hudson Trust Company in Hoboken. My publisher, John Wiley & Sons, is also based in Hoboken, but they’ve yet to pay me enough to bust the floor under my bank.

(6) Masaru Hayami.


Next up: On NIRP (Part 2)

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Please note that this post is intended to provide interested persons with an insight on the capital markets and is not intended to promote any manager or firm, nor does it intend to advertise their performance. All opinions expressed are those of Gregory Curtis and do not necessarily represent the views of Greycourt & Co., Inc., the wealth management firm with which he is associated. The information in this report is not intended to address the needs of any particular investor.


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