Negative interest rates – what does it mean and what must you do?

Negative Interest Rates Everywhere

Negative interest rates are all the rage among central bankers these days. Today even the usually so moderate swedes lowered the policy rate to a negative -0.1 per cent.

What should you do about it? What does it mean for your job security, stock portfolio, pension etc.? Read on…

(or skip to the very end for a few quick points on education, mortgage and stock market strategies in a NIRP world; Negative Interest Rate Policy).

Earlier this year, the Danish central bank did the same (several times, actually, over the course of a few weeks; going deeper and deeper into negative territory).

The European central bank, ECB, had since long cast off its previously conservative German heritage and gone negative. The same goes for the Swiss National Bank.

Not even the U.S. or Japan have gone negative (yet)

Amazingly, neither Japan or the U.S. have tried negative rates – otherwise strong advocates of monetary experimentation.

They prefer the more “moderate” stratagem of printing trillions of new dollars to purchase newly minted treasuries and bonds from their friends at the big banks instead. (The Treasury issues bonds that the banks buy. Moments later, the latter turn around and sell the bonds to the central bank at a slightly higher price, pocketing the difference. It’s a nifty way to enrich banks while simultaneously circumvent the rules against central banks buying bonds directly from the Treasury).

What Draghi (ECB) & Ingves (Sweden) et al. are trying to do vs. what actually happens

In theory lower interest rates, including negative ones, are supposed to:

lower  borrowing costs for companies (Lower borrowing costs mean more investments will be profitable and thus companies borrow more, invest and hire more people. Higher employment means more consumption and even more hiring in a virtuous cycle)

make banks safer (increased profits and strengthened balance sheets, thanks to lower funding costs due to, e.g., lower deposit rates paid to clients and lower coupons, or yields, on issued bonds)

lower the costs for households (lower interest rates on loans both directly and indirectly, as real estate and other companies get lower interest costs)

lower the borrowing costs for the government (reducing the burdens of a welfare state, enabling more transfers and subsidies)

stimulate more risk-taking (moving savers from zero-interest investments, like accounts and bonds, to equity and start-ups, thus promoting growth)

Increase inflation (higher prices and stable tax rates mean higher tax income for the state, thus making more room for welfare transfers. Higher prices on everything also means that loans [that are nominal] will fall as a proportion to income and asset prices. The latter is good for everybody with loans, but bad for everybody with savings)

What’s so special about negative rates?

Nothing really. What matters is the difference between nominal rates and inflation, adjusted for risk.

However, psychologically, nobody wants to pay money for the “privilege” of owning a bond or keeping money at the bank. Hence, people and decision makers feel forced to do just about anything with their cash, except keeping it idle at the bank.

In theory, when rates go negative, people spend their cash on more shopping and shares on the stock market.

Quantitative Easing (bond buying for newly printed money) aims to boost the effects of low rates

The Swedish central bank (SCB) today decided to accompany the negative policy rate with some bond buying. Most central banks do that nowadays. The Bank of Japan, of course, has done it for several decades (all but proving it doesn’t do any good).

The SCB started carefully with 10bn SEK (1.2bn USD), which would be equivalent to approximately 40-50bn USD in the US. The Fed typically buys in the trillions (1 Tn/year) so don’t worry; the Swedes still honor their heritage of moderation.

A 500% interest rate was the best they could do

A historical note: 23 years ago, when I was still at business school, the SCB raised its policy rate to 500%, manifesting beyond all doubt that it had no clue at all to what it was doing. Now the SCB is trying negative rates instead. I dare predict future economists won’t look back with admiration to today’s experiment either.

QE is thought to relieve weak hands of their bonds and put cash in their hands.

That cash then needs to be reinvested (and hardly in anything paying negative interest). The cash thus moves up the risk ladder into, e.g., longer term bonds, large corporate bonds, or even stocks with historically stable dividends. Gradually, investors at all levels are pushed further up the ladder and some money ends up at the very top; in new investments and start-ups, which should promote economic growth.

So, why ever have have positive or high, instead of negative interest rates? (or, what really happens is this)

If you buy into the Keynesian world view, where it’s a good thing to have politicians manipulate the economic cycle by varying interest rates and budget deficits, why not go “all in” and set negative rates once and for all?

Why not have ever falling rates, plunging deeper and deeper into the negative every year? Why have taxes at all, why not just issue debt to cover all welfare costs and let the central bank buy it all?

The intuitive answer is easy: It’s impossible, you can’t print wealth.

Money isn’t worth anything if you can’t get anything for it. Somebody has to work and produce. Somebody has to postpone consumption (a.k.a. “save”) for there to be anything to invest, for there to be anything produced. With negative rates there will be very little saving going on, but a lot of speculation and consumption instead.

Everybody knows you never go full retard in monetary policy.

The lessons from Zimbabwe, Venezuela and not least Germany (1923), are still fresh and raw in the memory of most economists. The death of money or hyperinflation is the most devastating economic phenomenon there is. Production ceases completely and an ever increasing bulk of money chases after an ever diminishing pool of assets and goods, fueling wild speculation and zero long-term investment.

Apart from doomsday scenarios, this is what negative rates means for you

In short, it actually means a doomsday scenario, just very slowly. The lo-down:

You’ll earn less interest on your bank account. Since most people don’t have any cash this is probably not a problem for you. If you have retired and live off a state pension, cash savings or bond coupons – tough luck!

Your variable interest housing loan becomes cheaper. Good for you, more money over for other things. Get out there and splurge!

Share prices, house prices and other asset prices rise for a number of reasons (most of them temporary and psychological). Good for you if you have all the assets you want. Bad if you were planning to buy more.

Companies start investing in anything they can find that might produce more return than the cost of borrowing. This means a lot of investments with lower return than usual get done. These lower quality projects fail more often. In addition, if interest rates rise, investors lose money even if the projects deliver as promised.

Short-term, the economy gets a boost, unemployment falls etc, as it did in 1996-2000 and 2003-2007, but when the low quality projects mature or interest rates rise, the true costs of low quality investing (malinvestment) become obvious. Remember that central banks lowered interest rates, to no avail, all the way down in the 2001-2002 and 2008 stock market crashes.

Longer-term, jobs disappear, banks fail.

The economy’s resilience and growth potential has been hollowed out by low quality investments. The easy job gains in real-estate, financial markets, service industries and consumption during the NIRP* induced boom are soon lost again. The loans for second houses, stocks, third cars, watches and other consumption go bad, consumption fall, and banks fail (subsequently rescued with tax money – congratulations all tax payers, they’re doing it again. But, no worries, the bankers will get to keep their bonuses from the boom).

*NIRP=Negative Interest Rate Policy

Inflation takes hold. Sooner or later inflation takes hold, due to more money and less goods. Then interests rise and many holders of variable rate mortgages will be toast. There actually already is rampant inflation – it’s just that it’s in assets, instead of goods. Whatever inflation there is in goods, the authorities choose not to include in the calculations, but there is a limit to how much they can hide.

Banks take more risk (and sooner or later go bankrupt) since they know the state and central bank will save the bank with tax payers’ money when needed. Up until the bankruptcy/state rescue bankers can pocket their bonuses and get to keep the money after the inevitable collapse.

Financial markets fall (they always do, sooner or later – and have already halved twice in less than 10 years; 2001-2002 and 2008-2009). Whatever artificial appreciation of stock prices accomplished today will be gone tomorrow. Bank failures in the wake of higher interest rates, malinvestments and bad loans is often a reliable way to start a market crash.

The value of a stock today is the discounted sum of about 25-50 future years of cash earnings after tax. Those earnings are being eroded, due to easy money, by current malinvestment and speculation, instead of sound long term investments in production. A mania in the wake of negative interest rates actually reduces the value of stocks, leading to lower lows in the downturn than what otherwise had been the case. Thanks Draghi! Thanks Ingves!

Enough with the economics and Fimbulvetr stories. What should you do now?

Should you fix your mortgage rate, borrow more, buy stocks, study, WHAT?

To start with, -0.1% isn’t that different from 0% or +0.25%, so you really could ignore the whole circus. As you were. In theory though… (and ceteris paribus):

In the short term things will look better. More employment, higher stock prices, higher house prices. In the long term things will still turn ugly.

This is how I would prepare:

Make yourself change resistant; don’t take your job for granted. Acquire more skills, make yourself indispensable, look for future-proof work places. Many will relax in the easy times of negative rates, but you should work harder than ever to secure your place in the job-less future to come.

Amortize your loans, or fix the rate for 7-10 years. Interest rates have never been as low as they are today. Don’t just do as all the other lemmings and go deeper into debt with variable interest rate – be contrarian and either reduce your debt (you can afford to amortize now that your monthly interest cost is so low) or fix the rate for a long time, in case inflation eventually ramps.

The family of two medical doctors I lived with when I studied finance asked me in 1990-92 whether I thought they should change their mortgage to variable interest (10-12% or so) or continue with 5-10 year fixed rates at around 12-15%. I repeated what I had learned in school (“you have always gained from variable rates”, except the very recent period). I hope they listened, because they were quite worried that rates might rise again, from 12%!

The coming decade, 2015-25, we are due such an exception again, where fixed rates are better than variable. Do you dare to time your fixing? Early 2015, late 2015? 2016? 2017?

I wouldn’t buy stocks or more living space. A very short summary of the entire article and the consequences of ultra-low rates would be “This already happened“. As I said, the small increment lower doesn’t change anything much. Stocks (everywhere) and house prices (Sweden; they never fell in Sweden during the financial crisis) have already skyrocketed due to ultra-easy money.

Stocks: Guess what will happen when rates rise, when profits fall, when speculation loses its luster, when growth expectations crumble… Do you think stocks will rise or fall then? Once again, remember that stocks crashed more than -50%, twice, while the Fed kept lowering its policy rate.

Once speculation fades and stocks are seen as risky (potentially negative returns to the tune of -10-60%), then zero or even negative rates in risk-free instruments will be seen as superior investment alternatives. As John Hussman keeps telling his readers, the writing is already on the wall in that respect, as gauged by increased dispersion of market internals (yield spreads, stock sectors etc).

In other words, investors are becoming more and more anxious and any little thing can topple that first crucial domino that fells the rest.

Stocks overshoot, and stocks undershoot. Respect that cycle and use it to your advantage rather than the other way around.


Obviously no consequence coming...

Obviously no consequence coming…

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