Would you pay someone to borrow money from you? Rest easy, I’m not hinting at the prospect of a mafia don on the other side of the transaction. Rather, would you pay your central bank 100 bucks today in return for 99 bucks a year from now?
Those of you who think I’m laying out a scam, ease up and don’t get your panties in a bunch. Sample these news stories instead.
“German consumer goods group Henkel sold € 500m of two-year debt with a yield to maturity of minus 0.05 per cent while French pharmaceutical business Sanofi sold € 1bn of three and a half year debt, also at a yield of minus 0.05 per cent”
“Roughly €706 billion of Eurozone investment-grade corporate bonds traded at negative yields as of September 5th or over 30% of the entire market, according to trading platform Tradeweb, up from roughly 5% of the market in early January”
“Around $13 trillion worth of bonds traded with a negative yield in late August, according to J.P. Morgan Asset Management. At the beginning of 2014, the figure was close to zero”
Now, bond yields are inversely proportional to the price that one pays for them. So, when yields are negative, an investor is parking money with the borrower in the hope that the bond will appreciate in value by enough to offset the loss in yield. In effect, the buyer of a negative yielding bond is betting on deflation and even lower rates in the future. Clearly, this is bizarre unchartered territory and I’m darn sure that Europeans, especially are smoking a whole lot of crack these days. An old adage says the first step to take control of your money is to stop borrowing. Well, that may not always be good advice. In fact, there are days (and nights) when I dream about an angel giving me the good news that with a wave of the magic wand, all Indian mortgages would now qualify for a takeover by Euro banks at negative interest rates. Unfortunately, that spell is almost always broken by Manjunath, the friendly credit officer at my mortgage bank who gives me the up yours sign and a pack of peanuts.
When unconventional monetary policy is the new normal
Negative interest rates (NIRP) are the next experimental idea on the lexicon of unconventional monetary policy. And that, my friends, is a story in itself.
Interest rates were first lowered to the zero lower bound when stimulus was needed in copious amounts back in 2008. Indeed, one cannot blame central banks for taking evasive action when the alternative was to stare at another 1929 style global depression. But when cutting rates down to zero failed to spark a recovery, Quantitative Easing (QE) was mooted first by the US Federal Reserve. The first concept in understanding QE is that “most” money in our economies is created by banks. So, when bank balance sheets are fragile and risk signs flashing, banks curtail lending and go slow on creating money. At the same time, households and firms are only focused on paying back their indebtedness – actions that destroy money. This is what happened in the years following the financial crisis. QE was a mammoth securities purchase program encompassing government bonds, longer dated Treasuries and Mortgage Backed Securities (MBS). The idea was that by buying debt and MBS from banks and non-banks, in exchange for money that is created fresh (Yes, electronically), the Fed’s balance sheet would swell by the amount of securities purchased and money supply in the economy would increase. Liquidity within the commercial banking system and among the crop of non-banks would thereafter percolate into the real economy and financial assets, pulling up their price and lowering yields. Finally, we’d have a new “lower” equilibrium interest rate that would spur borrowing, investing and spending. And Voila! We “should” have economic growth.
Well, in all fairness, the economy did get better even if the Fed balance sheet quadrupled to an obnoxious $ 4.5 Trillion by October 2014 when the taper was announced. However, opinion is divided on whether QE was the principal cause. Indeed, there are many credible voices supporting the argument that economic growth in the US came by in spite of QE and one should not confuse correlation and causation. My own personal view is that QE 1 (the first of 3 versions) was different and definitely made an impact because it was aimed at creating a market in stressed securities. What the Fed was doing then was swapping a bad asset for the safest asset – central bank reserves. The action did indeed bolster bank balance sheets in a very risk averse environment. However, what followed in later versions of QE was simply the swapping of a good asset for another good one eg: long dated treasury securities for reserve deposits. I doubt if the Federal Reserve seeded anything but an asset bubble in those later QE versions. I’d gladly devote a future blog post to the subject of QE’s effectiveness but for now, we’ve got to move into negative rate territory. Lo and behold, the Eurozone is here
An Out of Whack Eurozone
The European Central Bank (ECB) is responsible for the setting and operation of monetary policy within the 19 nation Euro area. Hoping to kick-start growth and fight off deflation, the ECB went a step ahead of the US Federal reserve and in June 2014, lowered one of its key interest rates to below zero. The ECB’s headline Main Refinancing Rate stands at zero while their deposit rate has been in negative territory since early 2016. This means that commercial banks pay the ECB to park their money in its coffers. In doing so, they became the first Monetary authority to try such a radical move. Monetary authorities in Denmark, Switzerland, and Sweden followed suit in the aftermath. The Bank of Japan too joined the bandwagon in early 2015 and as we’ve come to understand, the Japanese love the crazy stuff when all else fails. The ECB also launched its own QE style bond buying program in March 2015 – 6 years after the US, and hit the €1 Trillion mark in September 2016. The idea behind a negative interest rate was that banks would be discouraged from stashing away their money as excess reserves with the central bank. Naturally, profit motive would veer them toward lending to businesses, albeit at a low rate.
European Central Bank rates (2008 – 2016)| Source: Bloomberg, Eurostat
Every choice has consequences
“The very nature of creativity is coming up with things that haven’t been tried before”.
I came across this quote that very well sums up the status of monetary policy these days. Now, I do not vouch for either the Austrian economics or extreme free market position that blames central bank intervention for all ills and imbalances that we have today. However, it does baffle me that monetary policy is being written about as the “only f&#*”@! g game in town”. Let us understand that for the most part, central bankers are theoretical academics. They’re trying out things without really knowing if the results would be good or bad. Back in the days when QE was announced, we had Nobel laureate economists pronouncing it as a failure and potential source of hyperinflation. That didn’t happen and we now have the same group of central bankers trying out negative rates on the basis of a theoretical foundation that may or may not hold much water. There are however some early signs of the policy not delivering, and if perverse incentives kick in, it’s going to be messy.
Despite all the easing, growth in the Eurozone has been sluggish. The ECB only slightly increased its forecast of growth for 2016 to 1.7% in an early September meeting. Meanwhile, Inflation is devoid of ambition as the Eurostat figure for the year till August stands at 0.2%. The ECB target of 2% is probably in a parallel universe. The US managed to revive the patient by persisting with QE driven injections of cheap money. The Eurozone however, is not a single economy and to this day has a whole lot of walking zombies in the South. Italy, Portugal, Spain and certainly Greece are waiting to implode.
Euro area inflation and its components | Source: Eurostat
Sub-zero interest rates, meanwhile have started impairing the health of the banking system. When banks get charged for holding reserves with the central bank, their cost of doing business goes up, shrinking profit margins in the process. As I see it, quite many lenders will have to pass on the higher burden to their customers and mind you, this is a weak economy for savers as well. There is no way that the status quo can continue. In the interim, depositors can revert to the comfort of safe deposit boxes and repercussions are playing out in Switzerland where high value denomination banknotes are common. Here’s a Bloomberg take on the consequences
“Because of the low interest rate level, we note increasing demand for insurance solutions for the storage of cash….We’re seeing a demand for sums ranging from 100 million to 500 million Francs…Helvetia Holding AG says it charges about 1000 Francs ($1020) a year to insure 1 million Francs, a fraction of the 7500 Francs, a company would pay to park the same amount in a bank for a year, assuming the lender passes on the full charge. But that amount doesn’t include the cost of logistics such as transport or security features like reinforced walls, guards and alarm systems”
Another worry is that negative rates will push investors – banks and institutional players especially to take on more risk than before. Franklin Templeton’s Dr.Mark Möbius has waded in on the subject, highlighting it as a concern for pension funds whose goose is being cooked by their government bond portfolios. He believes that in the short term, more capital has been flowing into emerging market equity and bonds causing those markets to outperform. Of course, he doesn’t view this entirely as a cautionary tale for there are emerging markets that probably deserve more capital than bankrupt governments and moribund companies operating in demographically stagnant markets.
Are Negative Interest Rates Sustainable?
I believe that arguments in support of negative rates are weak. The line of reasoning is that when banks are punished and taxed for sitting on their money, they’ll lend them out. More so in the Eurozone case because commercial banks have a larger role in the transmission of policy (unlike the US where bond markets are an alternative). Those hopes may not be worth much and Cullen Roche, presents the counterpoint very well. I believe his thoughts on central banking are essential reading.
“Banks are not constrained by their ability to create loans out of thin air because of reserve requirements, savings or something else. To understand this idea, it’s better to start from the demand side. Remember banks are in the business of making loans. If creditworthy customers are walking in their doors, they don’t turn them down. And if the bank has adequate capital levels and deems the customer to be credit worthy, they write up a loan contract, expand their balance sheet endogenously (which creates a loan asset for the bank, a deposit liability for the bank, a deposit asset for the customer and a loan liability for the customer). And if needed, the bank will find the reserves to meet reserve requirements AFTER the fact from the central bank or via the inter-bank market. But in a healthy functioning economic environment, a well capitalized bank will service as many creditworthy customers as it can. After all, that’s their line of business”
Lower rates also do not address the real underlying issue – that weak consumer demand and business investment continues to prevail. It is only reasonable to expect companies to be wary of borrowing for new investments when demand for their goods and services is not increasing. Why would firms want to invest more just because credit is available cheap?
Monetary policy has its limits and nowhere is that more clear than in the Eurozone. With negative interest rates, the ECB is testing waters with a misguided idea to solve a problem that it really cannot, without significant Eurozone wide fiscal expansion. Fiscal policy meanwhile is unlikely to be exercised owing to German opposition. The Germans have always been suspicious of any discipline busting idea, at times even legitimate stimulus. In fact, even negative rates and QE may be under threat as voices within the BundesBank are turning more vociferous with the emergence of a new right wing anti Euro political front in Germany.
This post comes after a long hiatus. I’ve taken the pause to read up on a few things that interest me. Economic history was one revelation. I’m in no doubt that the obsession of economists to make the dismal science look like a poor cousin of physics in their models, language and interpretations has left us in a quandary. Economics and finance have to do with human behaviour first. The variability of behaviour doesn’t lend itself to models that are better suited to physical bodies. Yet, the academic realm is replete with folks who confuse and beat you down with concepts that intimidate first. There’s a beautiful quote attributed to Einstein “If you can’t explain it simply, you don’t understand it well enough”. Now, that’s a tough standard for one to pursue but surely worth a try. The times we live in offer great potential for a curious observer to dig up ideas that have bypassed mainstream economic thought but reflect the tribulations of our present. I’d like to be that curious observer. Nothing more!