Interest Rates: The Power of Negative Thinking 2


negative thinking 2

Stressed Out

While the main media is consumed with the economics of Bremain versus Brexit, I am going to return to the topic of ‘negative interest rates’.  It’s important to understand that, whatever the outcome of the referendum, that the world of finance is already very ‘stressed’.

And as a sign of that stress, we learned this week that over $10 trillion worth of government bonds and corporate debt now carries a small negative interest rate. In other words, in return for lending money for as long as ten years, you eventually receive a slightly smaller amount in return.

To put that last paragraph into context, the annual production of the UK is worth about $3 trillion. And the interest rate on the debt means that the associated bonds are the most expensive (i.e. good for the borrower, bad for the lender) in 500 years according to some data sources.

The problem for lenders is that they are competing with the leading central banks who via monetary policy are creating money to buy those same bonds. Last week I likened this evolving policy of QE to an old rugby song with the chorus, ‘next verse, same as the first – a little bit louder and a little bit worse’.

And the little bit worse this week was the beginning of a new programme aimed at buying corporate debt by the European Central Bank (ECB).

The stated aim of the ECB and others like the Bank of Japan (BoJ) is to create economic growth and moderate inflation. But the results of QE remain mixed and they appear to need to do progressively more to achieve less. And this medicine they’re prescribing is creating significant and worrying side-effects that I mentioned in the last blog.

It’s clear, however, that their intention is to continue on this aggressive path, while also considering more radical solutions. And they have plenty of backers. The Financial Times wrote an editorial this week endorsing such moves.

And the boat of alternative strategies that some believe would have restored credibility earlier has likely sailed. The restructuring of Greece, or lack thereof, is a prime example.


Will it work?

From my perspective I can’t know. The problem is I don’t think an academic economist working for a central bank can either.

Economic theory originally drew on the early laws of physics and it has serious limitations when you compare that theory with the real world.  This attempt to artificially maintain very low interest rates for a long time strikes me as more like the physicists’ concept of ‘entropy’. In other words, the more central banks seek to artificially set long term interest rates the more destabilised the system will become.


Special FX

As an example, when you ‘pressurise’ interest rates in this way the only escape valve for economic reality is via the exchange rate. This isn’t such a problem if all economic areas are in the same position as, but some are better and some worse.

If we compare the Eurozone with Switzerland, economically the latter is better. But last year the Swiss central bank did not want the franc to appreciate against the euro and hurt its exporters. So it tried to create an artificially low exchange rate, which ultimately failed spectacularly on one day in March as the franc rallied 25%. I wrote about it at the time here.

Fast forward to today and the Swiss are back to square one and trying to stop the franc appreciating again.  To do this they are making it less attractive to foreign investors by giving it a negative interest rate. And they’re also actively selling the franc and buying foreign assets. These assets are collectively known as ‘foreign reserves’ and are currently at the highest level ever for the swiss central bank.

China is a different story.  In some ways it is worse than the EU economic area, despite the official growth figures.  Like the EU, it’s trying to contain the interest cost of government and corporate debt through its own version of QE. But its overall debt levels are even higher than the EU’s and its currency has come under increasing selling pressure.

Fortunately, it already has huge foreign reserves built up via its positive trade balance with the world in recent years. And it can sell those to buy and stabilise its own currency – the opposite of what the Swiss are doing.  In the last two years its China’s reserves have fallen from almost $4 trilllion to $3.2 trillion.


What to do?

So while we rightly focus in the UK on Remain versus Leave, be aware that the tectonic plates of different currency zones are under a lot of stress at various points along their edges. If any volatility in the next month gets blamed on the referendum, remember that the economic backdrop is somewhat fragile in any event and prone to sudden adjustment.

The mispricing of rates and assets also means that we have to take great care and be especially wary with any income investment strategy. This will be as true of the trustees of pension schemes as those looking to grow and drawdown income from their own pension.

And it’s not just about the risk of prices moving up and down. It’s also about liquidity risk, the ability to get to your money when you want to.

I’d add, for those of you who might have a significant foreign exchange risk now, or sometime in the future, please get in touch and I’ll explain some options that are available to you.


Please remember:

  • past performance is no guide or guarantee of future returns;
  • the value of stock market investments can rise and fall over time, so it is quite possible to get back less than what you put in, depending upon timing;
  • this blog does not constitute financial advice and is provided for general information purposes only.

Interest Rates: The Power of Negative Thinking

A Song For Europe

 A long time ago in a bar far, far away (Yokohama actually) a former colleague introduced me to a song called ‘The cow kicked Nelly in the belly in the barn’.  The attraction of the song, especially to those with a little Dutch courage, lies in the chorus.

Next verse, same as the first,
A little bit louder and a little bit worse’

From an initial whisper, each verse grows a little bit louder and a little bit worse and eventually reaches a final crescendo at the limit of the singers’ lungs.

It is definitely not ‘Nessun dorma’, although the famous aria’s meaning of ‘None shall sleep’ is appropriate enough.  

And it’s not a very edifying sight. 

Which brings me to the financial version of the song being performed by the central banks of Europe (ECB) and Japan with others joining in.

We have already seen several verses of quantitative easing which are aimed at stimulating modest inflation and improving economic growth by lowering interest rates. But they haven’t been very effective. And it’s clear that central bank thinking is not that the policy is wrong, rather that not enough has been done.

So the ECB and others still want to be a ‘little bit louder and a little bit worse’.

And to achieve they are beginning to charge commercial banks for holding deposits with them. That charge is effectively a negative interest rate since the depositor gets a negative return on their money i.e gets back less than they started with.

In turn, the commercial banks are passing those negative rate costs onto their institutional and corporate clients with the largest deposits.

This BBC article by Andrew Walker does a good job of explaining what negative rates are and where they exist in a bit more detail.


Why push rates negative?

By imposing a cost on deposits, central banks are encouraging the regular banks and indirectly their largest clients to find better uses for their money, either in riskier investments or another currency. But it’s not that easy to find suitable debt or equity to invest in.

The earlier verses of quantitative easing have already distorted asset prices as returns have fallen due to artificially low interest rates.

As just one example of how this works, large companies in the US have gorged on cheap debt to buy either their own shares or those of other companies. That has supported equity prices to extreme valuations by some historical measures.  And with that extra debt there are now just two companies left that have the safest credit rating, triple A – Johnson & Johnson and Microsoft.

For banks, the problem is not just where to lend. There is the added problem that it may be difficult to pass their negative interest rate costs to all their depositors.  I explained in my last article that in order to implement negative interest charges with a bank’s retail customers you’d also need to limit access to cash, which is politically very difficult.

So profitability is likely to be affected at banks across Europe that are still repairing their balance sheets.

Negative rates and negative bond yields also change to whole basis of analysing how an investment performs over time. So they also affect those with long term liabilities such as a pension funds or insurance companies. And you’ll see that reflected in news of growing pension funding liabilities in Europe and elsewhere.

Germany is already pushing back against what it sees as an aggressive policy change.  But the ECB headed by ‘Super’ Mario Draghi rightly points out that it sets policy based on the whole of Europe.

He is also quoted in today’s FT as stating that low interest rates are also the result of a savings glut not just ECB policy. But by competing with that savings glut with the ECB’s own printed money he’s clearly and openly driving rates lower than they would otherwise be.  And the ECB hasn’t abolished risk as we saw in the collapse in the oil price and the debt of related companies.

So while to some the investing world might appear to be in equilibrium and seem like business as usual it really isn’t.  Central banks are playing a huge role in setting asset prices and they are still singing loudly.  And there are several verses of policy changes, some quite radical, that they could still employ.

I’ll cover those in a later blog.


The Chase

The danger for investors in this environment is that you start chasing investment propositions that seem to offer a reasonable yield, but where the underlying risk is not well understood.

The fact that something has worked well to this point or that the crowd is recommending it is not necessarily risk analysis. Nor is a fancy brochure or a nicely designed website with a fat investment return on it.

Unsecured retail loans, volatility trades, aircraft leases and catastrophe bonds, to name just a few, all offer yields that individuals can now get exposure to. But they are all forms of underwriting and proper risk assessment is very difficult. And I’ve considerable experience of debt and volatility trading.

It’s also important to understand liquidity, which is the ability to get access to your money.

Your current investments may prove to be far less liquid and more complicated and risky than you think. And that’s where serious errors can occur, either in unanticipated losses or your response to them.

The role of your adviser is, in large part, trying to make sure you avoid those mistakes.


Another ‘Song For Europe’

 I am sure there are worse ‘Songs For Europe’ out there…but here’s Father Ted’s spoof.

 Please remember:

  • past performance is no guide or guarantee of future returns;
  • the value of stock market investments can rise and fall over time, so it is quite possible to get back less than what you put in, depending upon timing;
  • this blog does not constitute financial advice and is provided for general information purposes only.