The utter insanity of negative interest rates

Dan Denning

The world of negative interest continues to get crazier. And not just crazier, but causing further distortions to the market, all in response to a sovereign debt crisis. Just to make that point a bit more clearly, you’re dealing with a low interest-rate world where you’re forced to take more risks to generate income because negative rates are good for indebted governments. The fact that they aren’t good for you is your problem, not the ECB’s.

Specifically, the stock of negative-yielding euro-denominated debt has grown 440% since the European Central Bank lowered interest rates on excess deposits to negative 20 basis points in September 2014. The UK’s BlueBay Asset Management showed a chart* (below) where negative-yielding debt exploded from €500bn to €2.7trn in a short time. The scariest thing? Nearly 40% of the negative-yielding debt was government debt. Take a look.


Insanity. Utter insanity!

Imagine someone asking to borrow money from you. The imagine them telling you they’ll charge you 20 basis points for the loan. Why would you ever make that deal? There are only a handful of (increasingly) non-sensible reasons.

First, you’re front-running the central bank. If the ECB tells everyone it intends to buy bonds, you want to be a seller. Buy now before more QE or stimulus.

If you’re an institutional fund manager playing with someone else’s money, it’s like walking into a casino and having the floor boss tell you, “If you play roulette today I guarantee you’ll make 3%”. It’s not a big win, but it has the appearance of being risk-free because the counter-party to your trade has told you what he’s going to do before he’s actually done it.

Why else? Well, there are currency reasons. If you’re betting on a euro decline, you’re making a kind of bet that European capital flows will go into a) higher-yielding assets denominated in other currencies or b) safer assets (presumably government bonds).

You could also be betting that there is no theoretical limit to public-debt-to-GDP ratios. This can keep on going for a long time. Japan leads the way. Is your government debt 150% of GDP? Don’t worry. Japan’s over 200% already! No problem. As a form of deficit financing, QE (indirectly) makes it possible for unsustainable trends to be sustainable for longer than previously thought possible. Not indefinitely. But for how long?

Nobody knows

Also, there is no theoretical limit to the expansion of a central-bank balance sheet. When you’re creating money from thin air, the well never runs dry (or the sky). There are only three possible limits on central-bank balance-sheet expansion: loss of political independence, the credulity of the fiat-money-using public, and rising interest rates (and inflation) due to variables beyond the control of planners.

The first two are related in the sense that central bank independence could be compromised by rising political interference, driven by the public’s loss of faith in ‘the system’. That’s happening to an extent, with the moves by the US Congress to audit the Federal Reserve. But let’s leave that aside.

The only other real risk to the ‘long-bonds-till-the-cows-come-home’ strategy is inflation. Bonds react quite negatively to inflation. All those investors accumulating bonds would be caught out by a sudden rise in interest rates or ‘unexpected’ inflation. Why aren’t they more scared?

Perhaps it’s because the real purpose of central bank QE programmes is not to produce 2% inflation in the general economy. It’s to enable low-cost, long-term financing of massive structural government deficits. The people extending that financing, the mega-banks of the world, are happy with the arrangement. And so are the people spending the money and counting the votes (the politicians).

What’s good for you and your money is largely left out of the calculus. This is one reason Tim Price wrote The War on Cash. To let people know what’s going on.

And to give them a plan to deal with it

In the meantime, don’t be so sure that interest rates can’t rise suddenly, or inflation can’t appear suddenly when confidence disappears. One of the reasons the trade looks so risk-free – one of the reasons it makes rational sense to buy a negatively yielding government bond with the intention of making a capital gain – is that you think you’ll have plenty of warning before the trade goes against you. You’ll have plenty of time to get out before the central bank signals its intention to allow or produce higher inflation.

That’s a dangerous set of assumptions. First, you’re assuming the central bank (operated for the benefit of government borrowers and banking sector lenders) won’t screw you. Why would you be sure of that? Second, interest rates can rise quickly due to ‘exogenous’ factors largely beyond the control of central bankers. One of those factors goes by the name of ‘war.’

* The chart we originally published did not include Switzerland, Denmark and Sweden as well as the rest of the eurozone. This is the correct chart.

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Category: Central Banks

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