Saturday, September 28, 2019
Donald Foster: The Enigma of Negative Interest Rates
As the contagion of the 2008 global financial crash (GFC) spread, central banks fought to restore confidence in global financial systems and re-generate economic growth. The main levers used were to lower interest rates and expand debt (quantitative easing/money printing) in the hope that it would be used productively to generate growth, stimulate inflation and with it the incentive for consumers to spend.
These measures together with fiscal stimulus were broadly effective and from Dec. 2015, the Federal Reserve in USA considered growth was sufficiently robust to progressively raise interest rates and reverse quantitative easing measures in order to restore some ‘normality’ to financial settings. But in the current year, widespread concern has emerged about tapering projections of world economic growth, and stimulatory monetary and fiscal policy are again being widely implemented to reduce potential for recessionary effects to take hold, but from much higher debt levels in relation to income than existed prior to the 2008 GFC (which itself was triggered by problems of excessive levels of private debt in USA), and from much lower interest rates than historically could be considered ‘normal’. The consequence is either that there is less capacity now to use those levers or use them with greater risk to the credibility of the global financial system.
Negative Interest Rates:
Lowering interest rates provides an encouragement to borrowers (private, corporate and government) to take on higher levels of debt. In the first instance, borrowers should know that governments through their central banks have inflation goals to meet which have the effect of progressively depreciating the value of the currency so the eventual repayment of the borrowed capital is made with currency of lower purchasing power. In the second instance, they will certainly know that if interest rates are reduced there is a lower burden against income required to service the borrowed capital, and therefore more incentive to borrow money. On the other hand, they should also be aware that the higher the level of borrowing against the income source used to pay that interest, the higher the risk of default if that income should fall or the rate of interest increase. In addition there is always the risk that the value of the project financed by the borrowing might drop triggering repossession or forced sale.
As far as theory or policy is concerned in principle though, a fall in interest rates engineered by the central bank should increase the attractiveness of borrowing regardless of whether rates are in positive or negative territory. How effective that policy is in creating economic growth depends on what sort of use that borrowed money is put to, but if rates were at, say, negative 1% p.a. thereby providing a tangible reward to borrowers to take on debt, but that reward was still not considered sufficient to outweigh concerns about the viability of taking on debt, then clearly a greater level of incentive would be necessary. Central bank measures pursued following the 2008 GFC were successful in restoring confidence and economic growth but with evidence of diminishing returns from the continuing expansion of debt. The resumption of those policies, with interest rates driving into negative territory risks the credibility of the financial system.
The conundrum about negative interest rates is to rationalise why any lender would be willing to lend money, with the inherent risk that involves, and in addition pay a service charge (negative interest rate) to the borrower through the term of the loan as a bonus for borrowing the money.
In theory, money is a commodity and its price (interest rate) is determined by supply and demand. The greater the supply of money (credit) there is in relation to demand, the lower the market price a borrower will need to pay to obtain it, assuming other things including velocity of circulation remain equal or constant.
For interest rates to go negative, though, there will be some question about the integrity of central bank policy. Why would a saver/lender/investor lend at a negative rate rather than simply hold and do nothing?
Savers/lenders/investors have a choice of investments they can purchase with the aim of generating income or capital gain, and the general maxim is that the greater the perceived risk of the investment, the higher the return should be to be to justify that risk. Generally government stock ranks at the lowest end of the risk spectrum, followed by fixed interest investments like bank term-deposits and corporate bonds, followed by non-monetary assets like property and equities at the highest end of the scale. Investment portfolios generally have a range of all these asset classes and the proportionate mix will be influenced by factors like the scale of the portfolio, the age and risk-comfort quotient of the investor, and so forth.
At the current time, over one third of global government stock on issue is being sold on market at negative yields, such yields being influenced by the perceived relative risk of the stock to the cash rate set by central banks which itself is a function of the supply and demand for money that will be reflected in the deposit and borrowing rates adopted by the trading banks. Most of this stock will have been issued with a positive interest coupon rate, but sold on market at prices so high that return to the purchaser is negative. There is also now US$4trillion worth of corporate bonds on issue that is being traded at a yield below zero.
But an increasing volume of global Government stock is now actually being issued at negative interest rates (Switzerland, Germany, Netherlands, Denmark, Japan and Austria), so the lender is actually paying the issuer a negative interest fee for the privilege of lending money to it. Given that government stock is issued for terms like 10, 20, and 30 years, during which time periods of rampant inflation (currency depreciation) may occur, this is heroic stuff. The rationale has to be that the purchaser believes on balance that it is more likely that recession, depression or a financial crash will occur during the stock term that has the effect of driving down the price of real assets like properties and equities so the purchasing power of the government stock will in fact increase to a much greater extent than the negative interest penalty paid to hold the asset.
Another possible reason is that many of the large fund managers handling government investment funds, company superannuation scheme investments, etc. are required by their mandates to hold prescribed proportions of funds in the form of government stock, so they may be obliged to buy such securities regardless of the rate of return on them. Trading Banks themselves may by regulation be required to hold government stock.
Returning to the ordinary saver/lender/investor, the question should be asked as to whether banks are safe enough to substitute for government stock so the greater negative rates on government stock can be avoided (at least at this juncture). Monetary assets are usually required at some level in their portfolios, and particularly for retired people, since they have a higher need for liquidity and certainty of capital than those with longer timeframes to deal with asset value volatility, and with a shortage of corporate bonds on market, banks are the option of choice in New Zealand whether by way of cash or term deposit. The security of cash or term deposits at banks varies and is affected by government regulations concerning capital structures of banks and whether deposits are guaranteed or insured to any prescribed level. In New Zealand cash and term deposits held at, that is, loaned to banks, are unsecured and subject to loss. While the banks are regulated to be able to withstand most commercial stress conditions, and are closely monitored by the Reserve Bank, those regulations may not be sufficient for banks to withstand a financial crash or loss of public confidence. For that reason the capital structures of banks are currently under review by the Reserve Bank, as is also the risk regime relating to cash and term deposits. The point is that as far as the saver/lender/investor is concerned, lending to banks involves a bigger risk than buying government stock and so a higher rate of interest or yield is required. As noted above, for the retired investor at least, there is a high need for monetary assets in the portfolio, however dismal the interest rate, including it being negative, unless the preference is to store cash under the mattress or find some liquid non-monetary store of wealth. Alternatively, they may lift the risk profile of their portfolios in a bid to lift returns, but suffer capital losses as their reward. This regime is particularly harsh to the retired sector.
It is clear that currency manipulation whether nationally or internationally on the scale evident since the 2008 GFC and the publicised determination by central banks to continue to pump money into the system to protect global growth is beginning to create some concern about the integrity of fiat currencies, evidenced by a surge in demand for precious metals, and in particular, gold, – not only by private investors but also by central banks, and a search for alternative pseudo currencies like bit-coin.
Currency manipulation, nominal and real interest rates:
Governments of each country nominate a currency deemed to be legal tender and used as a medium of exchange for the purchase and sale of goods and services. Such currencies are typically fiat and have no intrinsic value, but depend on public confidence that current market values attributed to the currency will remain stable. Like any commodity, the value of money is dependent on supply of it and demand for it and the task of managing the value of the currency is delegated by governments to their central banks, usually with a guiding inflation target like 2 to 3% per annum. That is, the central banks are tasked with manipulating the currency so that it loses value at the rate of 2 to 3% each year, considered to be a rate high enough to stimulate spending (rather than hoarding) and judged on balance to be beneficial to economic growth, but not so high as to destroy confidence in the currency. That said, the fact remains that the depreciation of the currency is a policy that penalises savers of currency denominated assets like cash or term deposits or fixed interest securities like government stock or corporate bonds (because the purchasing power of the capital sum is being eroded by government policy over time), and benefits borrowers (whether at personal, corporate or government level), because the sum borrowed is repaid with currency of lower real value than that which was loaned.
At the time of writing, a bank term-deposit for say $100,000 would typically earn an interest rate of 2.7% for a one-year investment term, while the latest available consumer price index measure of the annual inflation rate as at the end of the last quarter, 30th June 2019, was 1.7%. So, assuming a continuation of that rate over the term of the investment, it will take $101,700 at the end of the term to purchase the same level of goods and services as could be purchased with $100,000 at the commencement of the investment term. Nominal interest earned on the investment would be $2700 less personal tax of say, 25%, leaving an after-tax sum of $2025. Of that sum, $1700 is required to reinstate the purchasing power of the initial invested capital, and the effective real interest rate after tax is therefore only $325 or 0.325%p.a. (end-term repayment $102700 less income tax $675 less inflation-adjusted capital for reinvestment $101700 = $325.00). Clearly, nominal interest rates need only fall a little from present levels before savers will be earning negative rates in real terms.
It would seem the investment significance of inflation is only poorly understood by the general saver (surely to the relief of government which is happy to depreciate the value of the currency on the one hand and tax fictitious earnings in real terms on the other). Decisions about the use of money including investments are made on a daily basis and relate to current or future periods, whereas inflation figures are only periodically published and generally relate to previous periods, and consequently are somewhat esoteric for many people.
This analysis suggests that money held as cash or at very short term with NZ banks is in real terms already very probably in a negative interest range, but officials would not want to draw attention to that. It will only be when nominal interest rates turn negative that neither government nor central banks can deny a state of negative interest rates exists, and they will know that that is a point, psychologically, when the average person may question the credibility of the money system and currency.
The 2008 GFC was triggered by excessive private debt levels. Any solution that relies on further expanding global debt in relation to GDP, is fraught. Negative interest rates are a sign the financial system is moving into fantasyland. The measures intended to re-stimulate economies are themselves becoming a risk.
 Compared to earnings, US bond issuers are about 50% more leveraged now than in 2007. That is, debt has grown faster than profits. In 2009, BBB investment grade bonds (one step above junk status) represented 32% of the investment grade bond market, but that share has grown now to 50% (Mauldin Economics).
According to the OECD government debt is now a record high at US$93trillion and could become unsustainable. Corporate debt stands at US$101 trillion. A chart from Glidepath Wealth Management shows that world debt including government, household, and non-financial corporations at June 2018 was at 225% of world GDP.
 The Fed Rate in 2007 was 5.25% and by Dec 2008 had dropped to a range 0% to 0.25% and remained at that level until Dec 2015 when it recommenced a steady rise to 2.5% by Dec 2018. In July 2019 it was dropped to 2.25% and in Sept 2019 to 2.00% with a further probable 0.25% drop signalled for this calendar year.
 The RBA and NZRB have both recently lowered their base cash rates to 1%. Governor Lowe advised Parliament in early August 2019 that all options were on the table if the economy worsens including cutting rates to zero or even negative levels. Governor Orr has noted the need to recognise the moves made by other central banks in order to manage exchange rates appropriately.
The ECB has lowered its base rate to -0.5% and announced it will stay there a long time. Further, it pledged to buy 20 billion euros worth of bonds every month, indefinitely. In effect, the nations of the EU cannot afford to pay for their budgets, or their social programmes, so the ECB has moved down their borrowing costs to less than zero in most cases. (Mauldin Economics).
 For example, the central banks of Poland, Russia, China, and Turkey. In the first six months of this year, over 374 tonnes of gold was bought by central banks, up 57% on the same period last year with demand at the highest level since 2010.
Donald Foster is a retired company director.
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