Negative Interest Rates As Told by Alice in Wonderland

“Oh, you can’t help that,” said the Cat: “we’re all mad here. I’m mad. You’re mad.”

“How do you know I’m mad?” said Alice.

“You must be,” said the Cat, “or you wouldn’t have come here.”

Let’s start with the basics – as of August 2019 over $16 Trillion of government debt is being offered at a negative yield.  That means instead of getting paid interest, you are paying these governments a fee to store your money for you.  This is certainly not the hallmark of a normal or healthy global financial system.  Investors are a little nervous and rightfully so.

Negative interest rates are not just a localized problem in one or two markets but are occurring in several areas.  As of August 30^th, the German 10-year yield was at -0.70%, the Swiss 10-year was at -1.00%, the Japanese 10 year was at -0.27%.

The question is why would investors willingly pay a government to hold their money?  Sounds mad, right?  Well there are a few reasons this might be the case.

• Investors are becoming more concerned about the return of their capital, than the return on their capital. If more and more investors are worried about another major financial crisis, they might be willing to pay the government to keep their money safe.  It would not be unlike removing cash from a deposit account at a bank and paying for a safe deposit box to keep it in.

• Speculators are trying to cash in on a trend of lowering rates. Imagine you gave the German government $100 and are expecting to get $99 back at the end of the year.  That would be an expected return of -1%.  But then another investor says, ‘hey I will buy that bond from you for $101.’  The German government is still just obligated to pay the holder $99, but instead of actually losing money as you thought, you ended up making money by selling.  This is what is known as ‘The Greater Fool’ theory – a speculator buys an asset not on its merits, but rather with the goal to resell it to someone else at a higher price.

• Some large investors do not have any other options. Large pension funds, municipalities, and other large pools of capital may have constraints that do not allow them to take any kind of risk with portions of their money.  Therefore, they need to buy government bonds no matter what the return.

How did we get into this mess?

“Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!” – the Queen of Hearts

After the Great Financial Crisis of 2008, central banks around the world lowered interest rates in order to help stimulate their economies back to health.  However, just lowering interest rates was not enough as growth remained stubbornly low.  More stimulus was ordered and central banks began buying back bonds in order to add more cash into the system, trying to spur growth.  Still, it was not enough.  The Japanese government even started buying stocks in order to add more cash to the system.

Negative interest rates began with the European Central Bank (ECB) trying to stimulate their commercial banks into lending out more money by charging them a negative interest rate for short-term deposits. “Surely when faced with a decision of paying on deposits or lending out for a gain, banks will lend more money and economic growth will accelerate”, so the thinking went.

With all this monetary easing and stimulus, why aren’t we seeing growth?  It has been a hard question for economists to answer.  It seems like the more stimulus offered; the more stimulus is expected.  These governments have become like Alice and the Queen – running faster just to stay in the same place.  Meanwhile, economists and central bankers are suggesting that more stimulus may yet be needed.  Therefore, interest rates continue to drop and worried investors seek the safest assets they can find and end up putting their money in – you guessed it – more government debt.

Now how does this lead to an ‘inverted yield curve’ in the United States and why should we be concerned?

“Contrariwise,” continued Tweedledee, “if it was so, it might be; and if it were so, it would be; but as it isn’t, it ain’t. That’s logic.”

The central bank of the United States, the Federal Reserve (the Fed), has gone through similar exercises as the other central banks of the world but just less extreme.  Our economy has recovered faster than many of the other developed countries in the world so the Fed has worked at reducing some of the monetary stimulus that was put in place.  It hasn’t always been easy.  When the Fed announced in 2013 that it would reduce the number of bonds it was going to buy back, financial markets got nervous and the stock market dropped.  This was known as the taper tantrum.

The Fed operates under a dual mandate to a) pursue stable prices, and b) promote full employment.   Right now, we have stable prices, (inflation is less than 2%), and full employment, (the unemployment rate is around 3.7%).  So, the Fed has made a case that they can reduce monetary stimulus by adjusting short-term interest rates higher.  The only problem is that much of the rest of the world is still in a period of very low-interest rates and the market continues to push longer-term rates down.  Again, looking at Germany, an investor there can buy a 10-year bond in their home country at -0.72% or they can come to the US and make 1.50%.  While 1.50% is historically very low, it is still relatively much better.  Our higher rates and faster-growing economy attract money into our country and is a powerful factor in keeping our longer-term interest rates low.

When short-term rates are higher than long-term rates you get what is known as an inverted yield curve.  It is an oddity because you would typically expect to earn more on longer-term debt because you are assuming more risk by holding it for a longer period of time.  This is known simply as interest rate risk.  The market interpretation of a yield curve inverting is that investors are concerned that growth will be lower in the future.  This is why it is often treated as a sign of impending recession.

What should we expect from here?

“It’s no use going back to yesterday, because I was a different person then.” – Alice

What is considered a ‘normal’ rate of interest?  Do you want to go back to earning 5% on your money market accounts?  That would be great for people who have a lot of money in the bank.  But what about the people who are looking to buy a home, or get a business loan.  When interest rates were 5%, consumer and business loans were closer to 10%.  What is considered normal these days?

Like Alice says, we can’t look back at the way things used to be.  We were a different country 30 years ago.  We were a different country 10 years ago!  We need to consider how our country and our economy will look going forward.  Right now, the most likely scenario appears to be lower rates for a longer time.

Low-interest rates are a global phenomenon, and not something unique to any one market or geography.  For those of us in the United States, we do need to consider the rest of the world in considering which direction our interest rates will move.  The rationale for that can be summed up in this quote from Kyle Bass, founder and chief investment officer of Hayman Capital Management:

“We’re the only country that has an integer in front of our bond yields. We have 90% of the world’s investment-grade debt. We actually have rule of law and we have a decent economy. All the money is going to come here,”

If investor money from overseas continues to pour into the United States in order to get relatively higher interest rates in a faster-growing economy, than it is hard to see a natural path to much higher rates.  If ‘all the money’ comes here, it will keep interest rates down.

There is, however, a possible scenario where interest rates get shocked higher by some extreme event.  This could come in the form of a high-quality borrower suddenly experiencing financial difficulty, or the economy suddenly turning south.  While we do believe that the most likely outcome is low rates for a long time, we need to prepare for the possibility of a more severe scenario.

What are investors to do?

“Begin at the beginning,” the King said, very gravely, “and go on till you come to the end: then stop.”

You cannot just throw all your assets into the stock market and stay away from bonds.  Yes, bonds are currently ‘expensive’ at these levels.  However, we have to remember that bonds serve as an anchor in portfolios.  A bad year for bonds is down 5%.  That could be a bad week for the stock market.

What we are doing for client portfolios is sticking with each client’s specific asset allocation targets based on their unique risk tolerances.  A client with significant cash outflows, or getting close to retirement will still see a substantial portion of their assets invested in bonds.  We simply acknowledge the risks associated with bonds and work to mitigate them as best as possible.

Our strategy right now is to stay short-term on the bonds we buy, keep credit risk fairly low by buying high-quality bonds, and resist the temptation many other advisors take to reach for more income.  In a world with low rates, investors can blow themselves up by reaching for higher yielding securities without fully understanding the risks.

Final words

“Why, sometimes I’ve believed as many as six impossible things before breakfast.”
― The Queen of Hearts

When you hear people on the financial media saying “this low rate environment can’t last forever.” Or “We have to have a recession here soon.  This economic recovery can’t go on forever.”  Just remember that it can go on longer than most people think possible; that just doesn’t mean that it will.

Lord John Meynard Keynes is often attributed with the quote “Markets can remain irrational longer than you can remain solvent.”

Consider the following cases in point.

People have believed Japan’s debt burden completely untenable for 20 years.  They were supposed to have a great reckoning a long time ago as their demographics continue to get more challenging, and they continue to add to their debt load.  Today, they can borrow money for 10 years at -0.27%.  10 years ago, people would have thought this impossible.

Australia, despite being a very commodity-driven economy (mining and resources being main industries) has not had a recession in 27 years.  Our country is having the longest economic expansion in our history, but it is still just getting to 10 years old.  It is certainly not impossible for us to continue to expand for another 5 or 10.

We will continue to monitor the situation and adjust portfolios based on what we see is the most likely scenario, while paying attention to potential risk factors.  It is a fascinating time in the global markets because we have never seen an environment like the one we are in.  Negative interest rates and low inflation make for interesting, and potentially dangerous grounds for investors.

And, it continues to get more and more interesting every day. Or, as Alice might say – “Curiouser and curiouser”

Please contact one of our Trust professionals if you have any questions.

Keith J. Akre, CFA, CFP® – Trust Officer

Opinions expressed are solely my own and do not express the views or opinions of Stillman Bank. Investments available through Stillman Trust & Wealth Management (1) are not FDIC insured (2) are not deposits, obligations, or guaranteed by the bank and (3) are subject to investment risk including possible loss of principal.