Asking a fixed income manager about negative interest rates is like getting a taxi driver’s opinion on self-driving cars. You know that they are going to tell you that it’s a bad idea. But with over $5 Trillion worth of bonds having negative yields they are now a firmly established reality. Japan recently joined the negative interest rate club alongside Sweden, Switzerland, Denmark and the 19 countries that fall under the European Central Bank. These are a few thoughts on how we got to the scarcely believable point where 30% of the Global Bond Index now effectively entails the bond investor PAYING interest.
Negative interest rates are relatively new development
Positive interest rates have been around for a very long time. The Code Of Hammurabi (2130-2088 BC) capped interest rates at 33%. More than 4000 years later in 2009 Sweden cut its interest rate to -0,25%. There used to be a belief that monetary policy was limited by a “zero lower bound“, the view that interest rates could not go below zero as it was easy to escape negative interest rates by moving money out of the bank and into cash. The zero lower bound also reflected the view that it was inconceivable that a lender could be the one paying interest on a loan.
There is a new (lower) lower bound
While we have broken through the zero lower bound, as long as cash exists there will be some lower bound. This will be determined by the not insignificant cost of moving and storing physical cash. JP Morgan recently estimated that rates could go down to -1,5% in the USA and potentially -4,5% in Europe without a massive flight to cash. Any attempt to move rates even further negative would need to be combined with moves to make cash even more expensive to hold or even an outright ban. Attempts along these lines have already begun as the European Central Bank (ECB) is considering scrapping the 500 Euro note. In the United States, former US Treasury secretary Laurence Summers has been talking about scrapping 100 USD note, which accounts for almost 80% of the value of currency in circulation. The nature of politics in the USA makes me believe that a move to negative rates in the USA will be far more difficult than what we have seen in Europe and Japan.
Central Banks are figuring it out as they go along
When the ECB cut rates to -0.1% in June 2014, Mario Draghi announced that they were at lower bound for all “practical purposes”. In September 2014 the ECB cut to -0,2% and Draghi then said it was a technical adjustment and “now we are at the lower bound, where technical adjustments are not going to be possible any longer.” Then in December 2015 the ECB cut again to -0,3% and this time Draghi refused to say whether he believed they were now at the lower bound. The consensus is that they will cut further in 2016. The moves by the ECB shows how Central Banks are still figuring out the effects of negative rates and the extent to which they can cut.
Even as negative rates become commonplace, I don’t think that they are good policy tool for three primary reasons:
Reason 1: Negative rates are new and powerful weapon in the currency wars
Central Banks are resorting to negative rates in order to devalue their currencies. Countries like Switzerland and Denmark experienced large capital inflows while being pegged to the Euro and negative rates were an attempt to stem these flows. More recent attempts to move to negative rates by Japan, Sweden and the ECB strike me as competitive devaluations, which are an attempt to devalue a currency in order to make a country more competitive in global trade. Any attempt to maintain the currency at artificially weak levels is obstructive as I believe that free floating currencies are one of the best stabilizers in the financial system. They rebalance trade and capital flows by causing the currencies of relatively strong economies to appreciate, and weak economies to depreciate. Losing this automatic stabilizer leads to imbalances in the global economy and a build up of risks in the financial system.
Reason 2: Negative rates encourage greater leverage
Negative rates are an extension of the ultra easy monetary policy environment that has been in place since 2008. Monetary policy was used to save the banking system during the financial crisis, but is now seems to be the primary tool for driving economic growth. Monetary policy has substituted for fiscal policy or any form of structural reform. The problem with low (negative) interest rates, as the primary tool for growth is that, by design, it encourages an increase in borrowing. I believe that demand is weak because of excessive leverage, and any approach that increases leverage further is unlikely to solve the problem but just create greater financial risks. Structural reforms or some form of explicit wealth transfer (helicopter money) is more direct way of dealing with weak demand and the poor growth outlook.
Reason 3: We have reached a limit where there is little benefit to even lower rates
Japan’s recent attempts at monetary easing failed miserably and highlighted the limits to further monetary easing. The Bank of Japan cut to negative interest rates at the end of January in order to ease monetary policy and stimulate the economy. Subsequently, the currency appreciated 8% and the stock market fell 12%. That is exactly the OPPOSITE effect of what they had intended. Since 2009, Central banks have engaged in unprecedented monetary stimulus across the developed world. The example of Japan shows that we reaching a limit to how much monetary policy can do.