According to the Wall Street Journal, 16 percent of all outstanding government bonds on a global basis carry negative yields. For example, German two-year government bonds are yielding a -0.21 percent. If an investor purchased $10,000 of these bonds, they would receive $9,958 back in two years.
Recently, interest rates out to nine years were negative in Switzerland. Germany’s rates were negative out to six years, Denmark out to five years and Sweden out to four years. Why would anyone buy a bond with a negative yield? At first glance it doesn’t make sense. But before I explain why, a history lesson is in order.
Seventy five years ago economist John Keynes theorized that governments could stimulate economic growth by lowering interest rates causing companies to borrow funds to expand their businesses. And for the most part this approach has worked.
But this time around, as we tried to recover from the Great Recession, lowering interest rates to near zero failed to stimulate sufficient economic growth in Europe and Japan and it has had only marginal success in the U.S. It appears likely that both Europe and Japan are slowly moving towards another recession.
In my opinion, negative interest rates are a sign of desperation, a big red flag that traditional economic policies to stimulate economic growth have proved ineffective. There are two primary reasons why the European central bankers are using negative interest rates:
- To stimulate their economies by forcing bankers to lend their excess deposits to companies who want to grow their businesses rather than hoarding cash.
- To prevent their currencies from rising too quickly in relation to other world currencies. Negative interest rates discourage investors from buying the local currency, which keeps the value of their currency low. A weak currency keeps exports competitive which helps their economy.
There are several implications of negative interest rates. Both bank behavior and investor behavior are affected.
European Banking System: Central bankers are charging fees to commercial banks for parking their excess deposits with them. In other words, the commercial banks are no longer receiving modest interest on their reserves, they are being charged fees on their deposits. As I stated above, the purpose is to encourage banks to lend their money, not park it at the central bank.
Bank’s Reaction: So banks are beginning to charge their depositors a fee for large cash balances. Pause for a second and marvel how strange this is. Banks have always paid interest to depositors. We’ve entered a new era where banks accept money from customers if they are willing to pay for the privilege. But you’re thinking it could never happen here. Think again. JPMorgan Chase recently sent a letter to its large depositors that beginning this month it will charge one percent on deposits. Why? Jaime Dimon Chief Executive Officer wants to shed $100 billion in deposits to avoid paying the FDIC insurance on every dollar deposited within their institution.
Depositor’s Reaction: Several banks have discovered that depositors will tolerate negative interest rates to a point if withdrawing cash and storing it themselves is costly and inconvenient. But when negative interest rate decline sufficiently, it has been found that European depositors will withdraw their deposits and keep more cash on hand.
Investor’s Reaction: As a European investor there are three logical responses to negative interest rates:
- They buy their own country’s negative interest rate bond because they believe that deflationary forces will accelerate in the future, and interest rates will become even more negative. In other words buy now to avoid more significant losses later.
- They buy a negative bond from another country as a bet on currencies. If you are a French investor, you might think that the Swiss franc will rise enough against the Euro and that it will more than compensate for the negative interest rate.
- They buy U.S. bonds with a modest, but positive interest rate as a bet that the dollar will continue to appreciate in relation to the Euro. For example ten year U.S. treasuries are currently trading around 2.25 percent. In the past year the value of the dollar has increased 13 percent in relation to the Euro. So instead of receiving 2.25 percent on their investment, the European investor would actually receive 15.25%.
So will we follow the European example and see negative rates on U.S. treasuries anytime soon? Not a chance. But it will keep downward pressure on our treasury yields. Even if the Federal Reserve decides to increase interbank interest rates as predicted by the pundits, I doubt that will offset the hoard of Europeans buying our bonds. U.S. treasury rates should remain low for the foreseeable future, possibly lower.
But more importantly what will be the unintended consequences of central bankers using negative interest rates? And what will be the unintended consequences of central bankers purposely devaluing their currencies? Good questions but unfortunately no one knows how this is going to end. No one.
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Sources: Why use negative interest rates? by Andrew Walker, BBC World Service Economics correspondent, April 17, 2015; The Curious Case of Negative Interest Rates by Anthony Scaramucci, The New York Times, May 8, 2015; Less than Zero, When Interest Rates Go Negative by Jana Randow, Bloomberg QuickTake, May 13, 2015; “Nega-Coups” And the Implication of Negative Interest Rates On The Global Economy, by Bill Greiner, Forbes, March 12, 2015.