What happens when rates go under water?
Growing up, one of my favorite TV shows was “The Undersea World of Jacques Cousteau.” For an hour my family and I would sit in rapt attention, fascinated by the images of life in a coral reef, or under the polar ice cap, or even in a beaver pond. The series gave us a window into a strange, different world, where normal rules of gravity and body mass don’t apply—or, rather, apply in totally different ways.
We’re starting to experience a strange, new world in finance: the world of negative interest rates. Beginning in 2012 in Denmark, then Switzerland, and finally last year in the Euro-zone, European central banks have begun to charge member banks for the privilege of keeping money with them. This supposedly will encourage the banks to lend money to businesses and consumers. Instead of spurring lending, however, interest rates on low-risk government bonds have gone below zero. Just a few days ago, fourteen different European nations had negative two-year bond yields.
2-year Government Bonds on 10/22/15, Source: Bloomberg
When interest rates are negative, the normal rules of finance no longer apply. Future cash flows are no longer less valuable to an investor—they’re more valuable. That’s the implication of a negative discount rate. Also, instead of spending more as rates fall, consumers in Denmark have responded to negative rates by saving more. After all, when rates go negative, compound interest doesn’t help you reach your goals, so you have to set more aside. Finance has entered an underwater realm—a twilight zone.
Central bankers used to worry about what would happen at the “zero lower bound,” when rates approach zero. But zero doesn’t appear to be a boundary any more, it’s just one more rate level. Investors currently expect the ECB to lower their deposit rate from -0.20% to -0.40% at their next meeting. This policy isn’t unconventional, it’s experimental–an experiment in an $18 trillion economic zone with 300 million consumers. And the authorities are acting as if conventional laws of finance still work.
Some have written that central banks need to get rates back above zero, that savers and pensions and other investors need positive interest rates in order to survive, that capitalism itself is threatened by this experiment in emergency monetary policy. But the market is very inconsiderate: it doesn’t produce positive yields and returns just because we need them. Negative yields are here because of a host of factors. Central bankers aren’t leading the economy. On the contrary, the global economy is leading the bankers.
When Captain Cousteau explored the marine world, he found that different rules apply down there. It’s taken decades for us to understand and apply them. Hopefully, it won’t take that long to learn the rules of negative interest rates. Because the longer rates stay below zero, and the lower they go, the more pressure everyone will feel.
Douglas R. Tengdin, CFA
Chief Investment Officer