Are Negatives a Positive?Submitted by Trace Wealth Advisors on August 16th, 2019
Interest rates around the world have fallen to levels that many thought we would never see. Specifically, a good portion of the debt outstanding outside of the United States trades at negative yields. Yes, you read that correctly…you have to pay for someone else to owe you money. What a world!
There are a lot of questions out there about negative rates but they can basically be boiled down to two simple ones:
- How is this possible?
- Why is this happening?
Here is a brief explainer that might help clear things up a bit if you find yourself asking some variation of the above questions:
How is this possible?
There are really two types of negative rates to delineate between: nominal rates and market rates.
Nominal rates in this case refers to the stated rates of interest offered by fixed instruments. For example, if a bond is offering you a 5% coupon, 5% is the nominal rate. You may not be earning 5% based on paying an amount different than the maturity value of the bond, but 5% remains the nominal rate.
(Note: to make this more confusing, nominal rates can also refer to a particular rate minus inflation but let’s ignore that for now.)
Market rates are the returns offered by a fixed instruments based on current market prices. For example, if a one year bond has a coupon of 5%, a current price of $105, and a maturity value of $100, it is offering a market yield of 0% (you will lose $5 in principal but gain back $5 of interest).
So here’s one example of how it’s possible to have negative nominal rates:
Banks are required to keep a certain amount of cash on their balance sheet as part of their normal operating activities. Regulators (central banks) make them do this to ensure that at any given point in time, there is enough liquidity on the bank’s balance sheet to operate their business and keep the overall banking system safe. Many central banks (like the Federal Reserve in the United States) pay interest on these excess cash reserves. If a central bank wants to discourage banks from lending money, they might be willing to offer a higher interest rate to keep the money in cash rather than lending it out. On the other hand, they may want to cut the rate that they offer the bank if they want to make it unattractive to leave the money in cash and therefore have them lend more money out. But what if the banks still don’t want to lend the money out even when the regulator lowers the rate they’re willing to pay? Well, that’s when the fun starts…
I imagine the conversation between the central bank representative and the banker going something like this:
Central bank rep: “We want you to lend more money out to try to stimulate the economy so we’re going to cut the interest rate we’re paying you from 3% down to 2.5%.”
Banker: “OK that’s cool. 2.5% is still better than what I think I would earn if I lent it out.”
Central bank rep: “OK well in that case, I’m only going to pay you 2%.”
Banker: “That’s cool too. The economy isn’t so great right now and so really anything above 0% is cool with me.”
Central bank rep: “OK well in that case, I’m going to pay you -0.5%!!”
Banker: “Whatever…I guess it’s better than losing more than that.”
All kidding aside, the trick to understanding negative nominal central bank rates is to understand incentives. The central bank wants to make it so unattractive to hold onto capital that the banks are forced to lend the money, thereby stimulating the economy. The bank is incentivized to maximize its profits, however, and may believe that by limiting their losses they are doing just that.
And for those negative market rate fans out there, here is an example of how that might happen:
Suppose I am a German retiree looking to protect my capital in today’s environment. I know that if I invest in stocks, my returns will vary but those returns are unknown and so therefore it makes me uneasy. German government bonds, on the other hand, offer a known return which just happens to be negative. Which should I choose? Well, suppose that I don’t need the money but I just want to make sure it’s there in case I ever do need it. The answer is easy…you accept a negative return in exchange for knowing just how negative that return will be. I know it sounds a little crazy but it’s really not when you understand that there are quite a number of market participants, all with different incentives and desired outcomes…some of which don’t always make sense at first blush.
Why is this happening?
Short answer: I have no idea other than the fact that central banks are performing a gigantic experiment to try to stimulate their economies and bond traders are following suit.
Long answer: I still have no idea but here are a few other factors that play into this happening:
- Inflation is quite low throughout the developed world. In fact, deflation is still a risk in many areas of the world; central banks have to keep their nominal rates low in order to combat this. Since everything prices off of a risk free rate, negative risk free rates lead to low (or in this case negative) rates in other areas of the market.
- The population of the developed world is getting older and looking for savings vehicles, which, all else being equal, puts pressure on rates and moves them closer and closer to zero until one day….Voila!Rates are negative!
- The European Central Bank attempted to stimulate the economy by offering negative rates which they surmised would weaken the Euro and make European exports more competitive, thus stimulating business. A lot of other bankers took note of this and are following along in one way or another.
- People are still irrational and scared and they’re focused on the short term (note: this is always the case and so I write off almost anything to this explanation!)
So…my best answer still is the short one above which is that, like most things in markets, I’m not really sure why this is happening but I think I understand some of the root causes. Only time will tell whether or not negative rates serve their intended purpose. As you can hopefully see, while negative rates sound kind of interesting, they are a policy tool that need to be used very carefully.
If you want to understand the pervasiveness of negative rates in today’s environment, consider the following chart showing sovereign bond yields across the developed world:
Source: Bianco Research
Also, below are a few fun charts about negative yields from our friends at Deutsche Bank. The scope of this thing is kind of insane to wrap your head around once you see these. Incredibly low (or negative) rates are likely here to stay for the foreseeable future…
So...yea...this is kind of a big deal!
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