Economies are being slowly ‘suffocated’ by negative interest rates. Shan Saeed discusses its long-term repercussions.
screen-shot-2016-10-29-at-5-19-22-pmWe are witnessing the greatest turmoil in the global economy. Global financial markets are not behaving normally. After the financial crisis of 2008/2009, the term ZIRP became commonly used — zero interest rate policy. The major central banks throughout the world adopted policies of loose money and low interest rates, which typically go hand in hand. Global central banks have lowered the discount rate 649 times since Dec 2008.
The financial markets are not based on reality but on printing presses unleashed by the central banks from advanced economies. The growth patterns are abysmally low. So for the next 4-5 years, either some economies will have slow growth or no growth. The monetary expansion model is coming to an end. The path is rocky and many players are now scared about the markets. Brexit is done. Markets almost collapsed globally on June 24. Clients / investors lost USD1.2 trillion in one day. We are heading for an economic bloodbath/ financial armageddon in the next 9-17 months.
Global markets and players are losing confidence in governments and western policy makers as policy levers being applied by the governments are yielding zilch confidence. Remember the crisis months were September/ October since 1973, 1980, 1987, 1994, 2001, 2008 and 2015?
It pays off if you can fathom history/ economics/investment and geography. All the great analysts, bankers, mainstream media and top gurus were saying last year that global economy would grow at a phenomenal rate and economies (US, Europe, Japan) were coming out stronger than many expectations. All were wrong and misreading the financial markets.
Now we have gone from ZIRP to NIRP. If it weren’t already insane enough, we now have to deal with a negative interest rate policy. This means, the financial system is heading for more troubles as financial markets are getting unstructured returns. The risk-reward ratio in the markets is becoming skewed. This policy makes little sense. It is an attempt to repudiate the time value of money. Most people would rather have a dollar today than a dollar one year from now. And if you loan a dollar today to be repaid one year from now, you typically get paid some kind of interest.
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The interest rate represents a price on the money in accordance with the timeframe of the loan. The interest is compensation for giving up something today for someone else to use. The interest rate can also account for the risk of a default. In the case of most government debt, there is obviously a very low chance of any kind of a default, at least as perceived by the market.
Many countries in Western Europe have negative yields. Greece is an exception. The interest rate on a 10- year bond is close to 8%. There is still fear of a default. This does not appear to be the case in other countries in that region. With the news of Brexit, yields fell further. In many places, the yields appeared to go higher, until you realized there was a negative sign in front of it. Since then, stocks have recovered, but yields have mostly stayed down.
I can foresee 4 major risks due to NIRP to the global financial markets.
1. Financial impairment in the system
2. Disengagement with clients
3. Political backlash
4. Banks suffering losses. Deadweight loss in the system.
When you consider that major economic powerhouses such as Japan, Germany, Switzerland and Canada all have negative yields, there are going to be some major distortions in the market. And it isn’t just short-term debt that is paying out (or is that paying in?) negative rates. The 10-year yields in all three of these countries are negative. In Switzerland, even the 30- year yield has turned negative.
On a global scale, the total negativeyielding debt is now standing at USD13 trillion. You lend your money to someone and then you pay them the privilege of lending your money. This number is practically incomprehensible. It has gone up about USD5 trillion in just the last 4 months with the arrival of the Brexit vote.
The entire GDP of the United States is just under USD18.5 trillion. The total global debt with negative rates will likely surpass the entire annual output of the US, unless something turns around quickly. Maybe a tiny fraction of this negative-yielding debt is owned directly by the middle class. But most of it is owned by the big players. Some of it is owned by large pension funds that may not have many other choices. Some of it is owned by large financial institutions. Even wealthy individual investors may find few options if they seek safety. They would rather lose a small percentage instead of going into riskier assets where they might lose more. Of course, the number one owner of this negative debt is central banks. This is how they create money out of thin air — they buy government debt and then type in digits on a computer screen to the broker who sold the debt.
In the case of Japan, the central bank there is buying a large portion of the debt. It has ruined a culture of saving in Japan. The Japanese people have to find other ways to save. That is why sales of gold are up in Japan. It is also apparently becoming more common to hoard cash outside of the banking system.
But these policies have their consequences, one of which is to discourage saving. And when people do save, they are essentially forced to look for riskier investments. In Japan, the economic system named after its prime minister is Abenomics. It is basically Keynesian economics on steroids. With all of the massive monetary inflation and spending and debt, the economy is still a mess. It can’t even get a short-term boost from the artificial stimulus. Yet they keep going back for more. Japanese economy has reached a dead end and would suffer more.
The U.S. economy no doubt has a lot of problems. This is why so many people are fed up with the status quo, which has shown in the political arena. Fed had its own policy of loose money with the financial crisis. The government debt keeps going higher, despite a supposed recovery. Meanwhile, real incomes are stagnant at best.
But the Fed is playing its own game as compared to the other major central banks, most notably the Bank of Japan and the European Central Bank. While the rest of the world is awash in loose money and negative interest rates, the Fed has backed off. To be sure, the interest rates are really low in the U.S., especially by historical standards. The Fed has only raised its target rate once since the financial crisis, and that was a quarter-point hike late last year. Market interest rates have gone down.
And the Fed did have a really loose monetary policy from 2008 to 2014. It basically quintupled the adjusted monetary base. But while its balance sheet grew astronomically, price inflation has stayed relatively low, with fear and a lack of bank lending holding things down.
Since late 2014 — the end of QE4 — the Fed has been in tight money mode. The monetary base has been essentially flat. Yes, the Fed is keeping its balance sheet where it is. That is, it is buying more bonds with principal payments. And it is rolling over maturing debt. But it is not actively increasing the money supply like what Japan is doing now. So lower interest rates in the U.S. are not a reflection of central bank buying. This means private investors are buying up U.S. debt at low yields. The 10-year yield on U.S. Treasuries is now below 1.56%. [ July 23, 2016]. Whether it is foreigners or Americans, there is no question that U.S. Treasuries are seen as something of a safe haven right now. In terms of outright default, the investors are probably correct.
10 year treasury yield plunged below 1.37% and it could go down further. On June 23, 2016, UK voted “Leave” and shocked the world. Stocks crashed and global stock markets shed more than USD3 trillion dollars in just 2 days. That sent investors flooding into the safe haven of the U.S. treasury market, causing bond yields to plunge. The 10-year Treasury hit a record low of 1.35%.
And that sounds awful, until you consider this: America now stands as one of the last nations with positive bond yields. Central banks around the globe were already in a “race to the bottom” when it comes to interest rates before the Brexit. And that has accelerated in the last few weeks. US 10-year treasury was trading at 1.45% on August 1, 2016.
The Japanese 10-year bond sits at -0.28%.
The German 10-year Bund has fallen under zero to -0.099%.
Short-term bonds in France and Italy have both fallen into negative territory.
Post-Brexit, the UK may not be far behind.
Central banks were quick to offer emergency loans in the wake of the vote with the European Central Bank allotting USD442 billion in four-year loans to banks in the Euro region. The Swiss National Bank admitted to intervening in the currency markets in order to stabilize the Franc.
South Korea and India were among the other countries taking similar measures. This spring, European Central Bank head Mario Draghi pulled out all the stops and announced he was lowering rates and beefing up his massive quantitative easing program by another USD87 billion… and that was before the Brexit vote. Who knows what he’ll need to do now. Kuroda is printing money again amounting to USD3.7 trillion. The currency war game is very precarious.
According to the latest issue of Economist magazine dated July 22, 2016, the article entitled “Slow suffocation” clearly stated that the financial system isn’t designed to cope with low or negative rates.
Every time commentators say that bond yields cannot go any lower, the markets take delight in proving them wrong. After Britain’s shock decision to leave the European Union, yields dropped again. The income on 10-year Treasury bonds reached a record low, and German and Japanese yields headed further into negative territory.
The prospect that monetary policy would remain accommodating also helped shares on Wall Street reach new highs. Interest rates are the oil in the financial system’s engine, helping capital to flow from one area to another. There is a reason that rates have been positive for the past three centuries, despite world wars and the Depression. The system isn’t designed for a world of ultra-low, let alone negative, rates.
The traditional business of banking is to take money from depositors (a bank’s liabilities) and lend it, at higher rates and over longer periods, to borrowers (its assets). So an important driver of profits is the shape of the “yield curve”—the chart of interest rates for different durations. The smaller the gap between short- and long-term rates (the flatter the yield curve, in the jargon), the harder it is for banks to make money. The problems become even greater as bond yields near zero. Banks face resistance from depositors if they try to charge them for the privilege of having money in an account. Even as the return on banks’ assets declines, it is hard for them to reduce the cost of their liabilities.
When a central bank imposes negative interest rates on the reserves commercial banks keep with it, as what those in Europe and Japan have done, it is thus very hard for the banks to pass this cost to depositors. Negative rates act as a tax on bank profits.
When a central bank creates money out of thin air and institutes a policy of artificially low interest rates, it causes artificial booms. Eventually you get the busts as well. In the case of Japan, the economy is so bad that the bubbles aren’t even seen as a form of prosperity.
There is likely still a lot of malinvestment in the U.S. from the Fed’s previous monetary policy. At least in the case of the U.S., the Fed isn’t continuing to make it worse by creating even more money. The shakeout in Japan is going to be bad. It is not a matter of if, but a matter of when. The U.S. economy has its own issues, but hopefully we will not go down the same crazy path as Japan and Western Europe. You can also throw China in there, too.
Economic confidence is low, markets are moving from despair to near collapse (Brexit), market players are losing faith in policy makers (Europe, Japan, US), global central banks have borrowed future growth rate (ECB, BOJ, FED). Markets are moving according to Shanghai accord on Feb 26, 2016 agreed by 5 players (USA, Europe, China, Japan and IMF). These 5 players control two thirds of Global GDP and official Gold reserves. Empirically speaking, never in the recorded economic history, the following tools have created growth in the economy i.e.
1. Quantitative Easing (BOJ/ECB/BOE)
2. Negative interest rate (Europe/Japan/Canada)
3. Helicopter Money (Switzerland)
The above tools have created fear in the economy which is leading to subpar growth and economic depression. Capitalism does not work in slow growth or negative growth. It grows at a rate where people are making higher incomes, improving living standards and having higher purchasing power.
This may be part of the reason we are seeing a rise in gold and stocks as well. People are searching for yield. As long as we are not in a recession, it will be tough for investors to stay away from stocks. I continue to stay cautious on stocks, but you shouldn’t fight the trend, either. It is important to diversify, which can include some solid dividend-paying stocks.
Many voters protested about the bailing out of the very institutions that caused the crisis. Those protesters can take only cold comfort that the same policies are now slowly suffocating the industry. Tough times ahead for the global economy.
Bloodbath is here to stay for the long haul. According to market intelligence reports, clients would lose USD50 to USD70 trillion in the next 3-5 years. Global economy is in turmoil. The current crisis will last till 2020 and beyond.[/ihc-hide-content]

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