Easy For You To Say

Imagine you’re offered an investment. A prospective borrower explains the deal.

• You will loan them $101.00.
• In twenty years, the borrower promises to pay you back, but only $100.00.
• The borrower will not pay you any interest over the twenty years.

Do you make the loan?

I know what you’re thinking. “Of course not! If I make that loan, I am guaranteed to lose money.”

Well, that’s easy for you to say.

Today, all around the world, people are making that deal.

The world of negative interest rates

In July 2019, the Swiss Confederation borrowed roughly $410 million Swiss Francs (CHF) with a promise to repay just $406 million CHF in 2039 with zero-coupon payments. The yield at new issue was -0.05%.

Again, I know what you’re thinking! “What a terrible investment!” Well, today that investment doesn’t trade at the issue price of $101. No, today those bonds trade at $109. That is a tidy 8% return in just two months. Eventually, at maturity, the holders will receive only $100, but so far the price is up.

You’re thinking, “I would never accept a negative interest rate. I would just keep my money under my mattress.”

Money under your mattress

Keeping money under your mattress may work for small sums. For many years, economists believed that interest rates could not fall below 0%. After all, holding physical currency promises a 0% interest rate. Indeed, retail deposit rates across the world have mostly avoided negative territory.

However, in Switzerland, the Swiss National Bank (SNB) has set its Policy Rate at -0.75%. That means large Swiss banks who keep deposits at the SNB are charged on the money. So, when those 20-year Swiss Government bonds were issued in July offering -0.05%, that might have looked pretty attractive compared with deposit rates that were even more negative. But imagine you are the CEO of UBS. You would need a pretty large mattress to handle their roughly $420 billion in deposits. In a world with a lot of currency, most of which is held digitally, negative interest rates clearly can and do prevail.

Central banks go negative

The Swiss National Bank is not the only central bank to move policy rates negative. Weak growth and muted inflation in the decade since the financial crisis have central bankers around the world pushing the limits of monetary policy accommodation. Today, five central banks have negative deposit rates and most others are much lower than their historical averages.

Region	Bank Name	Rate	Description
Switzerland	Swiss National Bank	-0.75%	Policy Rate
Denmark	Denmark Central Bank	-0.75%	Deposit Rate
Euro zone	European Central Bank	-0.50%	Deposit Facility
Sweden	Riksbank	-0.25%	Repo Rate
Japan	Bank of Japan	-0.10%	Policy Balance Rate
U.K.	Bank of England	0.75%	BOE Rate
Australia	Reserve Bank of Australia	0.75%	Cash Target Rate
South Korea	Bank of Korea	1.50%	Base Rate
Canada	Bank of Canada	1.75%	Overnight Rate Target
US	Federal Reserve	2.00%	Fed Funds Upper Bound

Source: Bloomberg, dated 9/30/19

This past month has resulted in additional policy accommodation across the globe.

• September 13th, Denmark reduced rates from -0.65% to -0.75%,
• September 12th, European Central Bank drops rates from -0.40% to -0.50%,
• October 1st, the Reserve Bank of Australia drops rates from 1.00% to 0.75%.
• September 18th, US Federal Reserve drops rates from 2.25% to 2.00%.

The theory behind negative interest rates

Central bankers around the globe have different mandates and policies. However, in general, monetary policymakers view negative interest rates as stimulative. The theory states that if the cost of borrowing money is low, there is an incentive to borrow and invest in new projects. That spending should lead to economic growth and inflation that eventually allows for higher interest rates.

The criticism of negative interest rates

Critics of negative interest rates cite the transmission mechanism through the banking system as a weakness. If large commercial banks are unable to pass negative deposit rates on to their customers, who prefer the mattress option, those banks’ net interest margins become compressed. If the banks become less profitable, negative interest rates can actually create the opposite of their intended effect: harming, not helping, credit creation.

Another criticism is that regulations on financial services companies prevent them from making the type of riskier loans that may create faster economic growth. Reserve requirements that make banks and insurance companies safer, by forcing them to hold low-yielding government securities, also restrict their ability to finance new projects.

Who issues negative-yielding debt, and who owns it?

Today there is over $14 trillion of debt that trades at negative interest rates. The vast majority are securities issued by governments in Japan and Europe, but some is even issued by corporate borrowers.

The owners of these securities are largely central banks, pension funds, insurance companies and other investment pools like mutual funds.

Could negative rates come to America?

I know what you’re thinking. “Sure, there is $14 trillion of negative-yielding debt, but that’s Japan’s problem, that’s Europe’s problem. We won’t have negative interest rates in the United States.”

You might be right. Even in the depths of the financial crisis, the Federal Reserve did not turn to negative interest rates to stimulate the economy. However, no less a public figure than former Fed Chairman Alan Greenspan disagrees. In an interview last month, he said it was “only a matter of time”¹ before negative rates spread to the US.

Here’s his logic:

The US is experiencing the longest economic expansion in recorded history, now over 10 years in duration. At some point, the business cycle will turn and we will have a recession. During recessions that coincided with inflationary periods in the 1970s and 1980s, the Fed dropped the Federal Funds rate an average of around 10% to stimulate growth. In the last three recessions, the Fed cut rates by 5.5% on average. Today, after two cuts in 2019 totaling 0.5%, the Fed Funds rate target stands at 2.0%.

Mr. Greenspan believes that the next recession will require more than an additional 2.0% cut to recover. The question to us is whether alternative monetary policy actions, such as quantitative easing, will be sufficient to avoid negative rates in the future. Several members of the Federal Reserve have voiced their dislike for negative rates, including Fed Governor Lael Brainard and Fed Chairman Jerome Powell.² We hope, for the sake of our investors, that the US economy stays strong and we can avoid that path.

Options for investors

When faced with low expected returns investors have four options:

Take more risk: Take more risk in an attempt to generate returns similar to what you may have earned in the past (in this case, owning fewer safe bonds and more high yield and equities).

Market timing: Wait. Attempt to “time the market” and hope a day comes when expected returns are higher (in this case, higher interest rates).

Stay the course: Continue to invest as you have historically and adjust your spending/budget projections to reflect lower expected returns.

Alternative investments: Attempt to find investment strategies that are less dependent on the level of market returns in the future.

Unfortunately, that is it. We dislike Option #1, as our clients rely on us to prudently manage their investment risks. We view the probability of success with #2, market timing, as extremely low. For now, we are mainly relying on investor education and our team members in the client centric team to help our clients navigate the planning implications of lower interest rates (Option #3). We are also utilizing Option #4, with allocations to alternative investment strategies with track records of uncorrelated investment performance.

Conclusion

I wish I could say with certainty that we will never own negative-yielding bonds here at Greenleaf Trust. We believe the odds are low, but we also believe that it is possible negative yields may come to the United States. It is distinctly not easy for us to say. If they ever do, you can rest assured that the team at Greenleaf Trust will be here to help you navigate the planning and investment implications to help you reach your financial goals.

Sources:

1. https://www.cnbc.com/2019/09/04/alan-greenspan-says-its-only-a-matter-of-time-before-negative-rates-spread-to-the-us.html
2. https://www.bloomberg.com/news/articles/2019-09-11/fed-loath-to-follow-ecb-on-negative-rates-despite-trump-s-demand