What are negative interest rates telling us?
The short answer (or TLDR) is that something is very wrong in our global financial system which is worth paying attention to.
To get at the longer and more useful answer, let’s start with a quick look at where negative interest rates have popped up: primarily Japan and Europe.
At first it was just the Japanese.
Most of us chose to dismiss this as something particular to Japan. It is a pretty cool and unique place, after all.
Japan’s economy has been in the doldrums since 1989. The population is aging at an alarming rate. Deflation is stubborn. And, the Bank of Japan doesn’t want its currency to strengthen. To add to the contrarian feel, Government Debt to GDP hovers around 240% having spent the last 10 years over the 200% mark.
Experienced JGB traders will mumble something about domestic insurance companies when pressed.
Then it was Europe.
Well, we all know the Germans save too much, one might say. Mario Draghi was too successful defending the Euro at the European Central Bank. And who remembers the PIIGS (Portugal, Italy, Ireland, Greece and Spain) and how they were going to tank the EU, anyway?
So, Greece (yes, that same Greece!) just slipped a half billion Euros worth of 13 week paper into the market at -0.02% yield. Germany has floated a big 30 year zero coupon bond out there with a negative 0.11% yield.
Intelligent comments on how both ends of the curve are anchored in negative territory? Don’t hold your breath.
How did we get here?
Economies around the globe have been putting themselves back together since the Global Financial Crisis of 2008 with asset inflation. This is not a new trick. A version of it was deployed after the dotcom bust and the 9/11 attacks in the US with deliberate interest rate policies to pump up the property market.
This time, we pumped up the bond market. Which bond market, you might ask? Frankly, any bond market would do. Whether we are talking about the expansion of the Federal Reserve balance sheet from the $900bn (2006) to $4 trillion mark or Mario Draghi promising that the ECB “is ready to do whatever it takes to preserve the euro” in 2012 (and proving it), Central Banks have acquired massive bond positions in the global financial system. The FED peaked at 25% of GDP and has dropped back to around 20% (traditionally more like 6%). The ECB is estimated to control a balance sheet of around 40% of GDP. But, the Bank of Japan still wins by starting a few decades earlier and building a balance sheet equivalent to 101% of GDP.
And, by the inexorable math of bonds, when one drives down the yields, one pumps up the values. Other long term asset prices (stocks, property and the like) couldn’t help but go up dramatically as the price of money (for institutions, mind you, not credit card or student loan balances) fell to almost nothing.
So, that is interesting. What happens now?
Clearly a fair number of traders, for whom this is the day job, think that there is more upside in the trade. What happens to the price of a 30 year sovereign zero coupon bond trading above par is really anyone’s guess. But it will be epic.
For most of us who do not trade every tick of the market, there is a squirrelly feeling that the good times cannot persist forever, or more specifically, that much longer. The EU is flirting with recession, China’s growth rate has throttled back and the US is closer to the end of its current expansion cycle than the beginning if history is any guide.
That means savvy investors are looking to shift some of their assets into low duration assets (in layman’s terms, cash). Cash has the benefit of not falling when everything else is and being “dry powder” to pick up assets in the trough of the cycle.
The most efficient way to put away some extra cash today is to deposit it directly with the Federal Reserve. That is the preferred method for the member banks, the most sophisticated players in the financial markets, who are also shareholders of the 12 separately incorporated Federal Reserve banks.
Unfortunately for the rest of us who are not members, access to this 100% reserve backed bank facility is not available. From time to time, one might see an article musing about allowing direct access through accounts or even something as exciting as a digital FedCoin. However, these initiatives are unlikely to overcome the resistance of the member banks anytime soon. Think turkeys voting for Thanksgiving; taxi companies welcoming Uber…you get the picture.
The next best way would be to buy some paper directly from the Treasury. The Treasury regularly auctions short term bills and if you do not wish to or are not required to hold them through a financial intermediary, you can hold them directly registered with the Treasury, your counterparty on the asset. China and Japan are the two largest holders (switching first and second place from time to time) because treasuries are considered some of the most secure and liquid assets available in the market and who wouldn’t like to have that backing one’s currency.
After that, you are in the world of financial intermediaries. For banks, that means fractional reserve arrangements which are vulnerable to negative sentiment, leading to bank runs. For money market funds, there is at least one and perhaps more layers of financial intermediaries between you and the actual asset/counterparty. The problem isn’t that a crisis will wipe out all the value. It is that, in a crisis, access to that value may be limited or blocked for an uncomfortable amount of time.
The worst choice is to fill up your mattress and/or bunker with paper currency. While a dollar bill does represent a direct, unintermediated obligation on the Federal Reserve, paper storage does not scale well. At levels exceeding FDIC insurance, it is expensive to store securely. And of course moving it in large quantity is sure to bring the unwanted attention of FinCEN.
So, in conclusion, it looks like there is still some significant unfulfilled demand for cash and near cash assets in the near term that do not have financial institution risk (FI risk) baked into the ownership structure.
Is the concern over FI risk overblown? Perhaps. But then again, no one seriously considered the possibility that a sub-prime mortgage bubble pop could take out top-drawer names like Bear Stearns, Lehman Brothers, Merrill Lynch, Fannie Mae, Freddy Mac and AIG in 2008. And on the same day the Fed took over AIG, no one thought a money market fund called Reserve Primary Fund would “break the buck” in the functional equivalent of a bank run (massive redemption requests).
It is not a coincidence that Bitcoin was launched in 2008. Innovations since 2008 have moved ever closer to providing the key components of an ownership structure that eliminates unwanted intermediation and asset profiles that more closely match the needs of investors. The innovations continue and soon it will be weird that people thought that FI risk was actually something that people had to pay for.