Submitted by Michael Lebowitz of 720Global
Hail Mary
Over the past 30 years, many central banks have tried to re-order the natural drivers of economies. As opposed to savings and investment driving production and consumption, they moved consumption to the front of the line, meaning it came at the expense of savings and investment. These efforts disrupt the natural order of activities in a healthy economy and encourages an economic cycle fueled by debt. Central banks’ model, as shown below, illustrates how ever-lower interest rates are used to encourage additional borrowing to drive consumption and lift asset prices; all in the hope of ultimately achieving economic growth.
Currently economic growth in most of the largest nations is deteriorating, and once again the central bankers are grasping for remedies. However today is different than the past. Unlike prior instances of stalled growth, the central bankers’ main policy tool, interest rates, has reached a supposed limit of zero percent. To combat the situation, some central banks are employing a new tool to preserve the cycle shown above. The method to their madness is a negative interest rate policy (NIRP). This article describes a NIRP and related matters every investor should be considering. It also discusses a link between NIRP and a recent appeal of some leading economists to fight crime by eliminating large currency denominations.
A better understanding of negative rates may lead you to our opinion that the concept of a NIRP is sheer desperation akin to a last second Hail Mary pass in football, but with even lower probability of success.
Negative Interest Rates
A negative interest rate is a simple concept, yet those promoting such an economic remedy make the matter sound like a PhD dissertation and appear to be confusing the public. Before explaining what negative interest rates are, and why a central bank might promote them, we share a few headlines to highlight their developing global popularity:
When making a deposit in a bank, one is electing to forego consumption today and save money for the future. A deposit is effectively a loan to the bank that can be withdrawn at a future date without notice or penalty. Traditionally, banks pay interest on deposits to compensate for the time value of money as well as the potential default risk associated with the bank. As importantly, they also pay interest on deposits to incent people to forego consumption and allow the bank to leverage the deposit into higher yielding loans to other borrowers. This arrangement has defined banking since its earliest roots in ancient Greece nearly 4000 years ago.
Negative interest rates, however, are quite a different arrangement. They essentially ignore or negate the time value of money and any default risk associated with the entity charging negative interest rates. For example, imagine depositing $100 into your bank account only to find out that you have $98 left when you go to withdraw it in a year or two. Not only were you not compensated for the time value of money and the default risk assumed, you actually paid the bank while still assuming these risks. Equally confounding, assume you approached your mortgage banker to take out a mortgage to purchase a house and were told that you would be compensated monthly for taking such action. Welcome to the world of negative interest rates. It really is that simple; and that bizarre.
Why a negative interest rate policy?
To consider why central banks are promoting a NIRP we need to understand their goals and the tools at their disposal to achieve them. Most central banks are entrusted with the important role of managing their nation’s monetary policy to enable strong economic growth, full employment and moderate inflation. To accomplish this feat, many central banks adjust short term interest rates to influence borrowing, investing and ultimately consumption.
Over the last 30+ years many central banks have become increasingly dependent upon lower interest rates to meet their economic goals. Think of this strategy as continually pulling forward tomorrow’s consumption to today. At some point you run out of tomorrows. The following graph shows the rise in total credit outstanding, GDP and the Federal Funds rate (the rate the Federal Reserve adjusts to influence borrowing and lending) in the United States.
Total Credit Outstanding, GDP and Federal Funds Rate
Data Courtesy Bloomberg
The sharp increase in total credit outstanding or “debt”, relative to the increase in GDP, is a reflection of the rising leverage driving economic activity. In the 1980’s it took roughly $1.50 of debt to generate $1.00 of output. Today the economy needs almost $5.00 of debt to generate the same $1.00 of output. Borrowing for long periods of time in amounts greater than your ability to service the debt with economic output, as shown above, is only possible with low interest rates and/or very gullible lenders.
Since 1995, U.S. Treasury debt outstanding quadrupled, however the total annual interest expense paid by the Treasury remains roughly the same. Declining interest rates make refinancing existing debt with new debt cheaper, and prolongs the borrower’s ability to service that debt, but there is a limit to how effective such a policy can be. It seems plausible that as debt levels expand and most nations approach zero or even negative rates, that limit is being reached.
Cash
The investment asset class most affected by negative interest rates is cash. Cash is a term investors’ use synonymously with money invested in the money markets. The term also applies to bank deposits, but for purposes of this article, we focus on funds invested in money market mutual funds. Money market investments are considered “money good” by many investors. In other words they are as “risk free” an investment security as one can find as there is the belief is that there is little to no risk of loss of principal. Money market mutual funds typically invest in short term fixed income products, such as U.S. Treasury Bills, collateralized lending agreements, certificates of deposit and high quality commercial paper. Many U.S. money market funds are governed by the U.S. Securities and Exchange Commission (SEC- 1940 Act -Rule 2a-7) which imposes very conservative limits on the assets these funds can hold and the way they manage their investment portfolio to ensure minimal risk of loss.
In todays near-zero interest rate environment, money market funds are struggling to earn enough interest to pay a return to shareholders and cover their expenses. Many funds have cut their expense entirely. This situation is exacerbated when worsens fund holdings incur negative yields. In this scenario money market funds are forced to either pay to manage clients’ money or devise other strategies to pass the costs of negative-yielding investments onto fund holders.
Such a negative interest rate situation is currently playing out in Europe as the ECB adopted a NIRP, which drove yields on many money market instruments in Europe to below zero. Europe’s largest money market funds are taking action. One mechanism to pass on the costs to fund holders allows the funds to reduce the number of shares its investors hold but leave the net asset value constant. For shareholders this is similar to the previous example where you deposit $100 in your bank and see your deposit shrink to $98 over time. We suspect other legal, but deceiving, approaches will be employed to enable money market funds to keep their net asset values constant despite negative returns. Money market funds are not a charity. They will find a way to pass on the costs of negative yields on.
A NIRP, per the central bankers’ plans, will force some investors from the security of money market mutual funds into riskier assets. Short term commercial paper, municipal bonds and longer term Treasury notes may likely be in greater demand by such investors. Other investors may look to hard assets such as gold, silver and other commodities to help preserve their purchasing power. In both scenarios, cash investors aiming to avoid paying for safety will have to accept more risk.
Can more debt solve a debt problem?
In our article “The First Rule of Holes” we mentioned how monetary policy has increasingly encouraged more debt with little regard for the ability to service the accumulating debt on an individual, national and global level. If the intention of negative interest rates is to incur even more debt, one must question whether a continuation of the monetary policies that created the problem in the first place can actually solve the problem. We impart the wisdom of Will Rogers to help guide the central bankers: “When you find yourself in a hole, quit digging”
Furthermore, we should also consider if there is clarity among policy-makers around the extent to which the global debt burden is causing weak and stagnant economic growth. Productivity growth in the long run drives economic growth. Unfortunately, productivity growth has been steadily declining globally, a likely symptom of the buildup of unproductive debt. Consider the chart below showing negative trends in productivity growth for the world’s 10 largest economies. Note as well that 7 of the 10 economies are currently witnessing declines in productivity. The U.S. is leading the world’s largest economies with a paltry .33% productivity growth over the last 2 years and is on trend to follow most major economies into negative territory.
Global Productivity Trends
Data Courtesy: The Conference Board
Financial Discipline
Governments and their central banks should encourage and reward financial discipline. Avoiding bankruptcy and the evils that accompany it are lessons everyone should heed. Strangely though, the idea of saving money appears to be a sin in the eyes of central bankers. Those exercising fiscal discretion are being punished by what amounts to a tax on their savings in the form of a negative interest rate. Is this a prudent message and does it seed societal problems as an unintended consequence?
As children we were properly taught by our parents to save money for a rainy day. The actions and policies of the central banks are now telling us that we should teach our children to disregard prudence and spend money like there is no tomorrow.
What does banning large denomination currency have to do with NIRP?
It is at this time when a NIRP is gaining popularity globally that we take notice that some of its loudest supporters including Larry Summers, former Treasury Secretary, and Mario Draghi, the current President of the European Central Bank (ECB) are advising an end to the issue of large currency denominations. They claim removing these bills will make criminal activities harder to commit. To their point, forcing a criminal to transact with two suitcases full of $50 bills instead of one suitcase full of $100 bills will complicate mischievous endeavors.
Having to resort to negative interest rates is not normal, despite efforts to sell it otherwise. In our opinion it is a desperate effort aimed at maintaining a faulty economic model amidst crumbling support as witnessed by perennially weakening economic growth and soaring debt levels. Drawing a link between NIRP and the sudden interest in eliminating the $100 bill in the U.S. and the €500 in Europe is not a stretch.
We believe the proposals to eliminate large bills are being conducted under the guise of thwarting criminal and terrorist activities. The reality is that eliminating large bills gives the government and financial system more control over the financial activities of the population. Making cash withdrawals more difficult, lessens the likelihood that individuals avoid the penalty of negative interest rates by storing cash outside of the banking system. Hoarding of cash reduces the ability of a NIRP to push savings into consumption or speculation.
At the end of the day these proposals have little to do with stopping crime and much more to do with extending the power of the banking sector and financial authorities to socially engineering an outcome they want to occur (i.e. individuals spend every dollar they have).
Summary
Negative interest rates are a tax! Not a traditional tax paid to the government, but an expense paid, on savings. Years of policy designed to encourage spending and discourage savings is likely reaching the end game; the point where those exhibiting prudence must be punished to keep the game going.
At some point, and likely soon, central bankers will be forced to realize the efficacy of lowering interest rates is vanishing and is hindering achievement of their goals. When this occurs a paradigm shift in the way monetary policy is conducted will likely occur. Investors that understand this dynamic, and what it portends, will be in a much better position to protect and profit from the asset price adjustments that lie ahead.
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