Why So Negative?

What the future might look like should the U.S. Fed adopt the policies of the central banks in Europe and Japan.

Despite the current data in the United States, the gloom and doom crowd are not backing off. I remain optimistic on the economic outlook and expect rates to rise, but the bearish argument is not implausible or impossible. For the purposes of the rest of this article, let’s look at what the future might look like should the U.S. economy falter and the Fed adopt the policies of the central banks in Europe and Japan.

Negative Rates

Negative interest rate talk was all the rage until the past couple of weeks. That talk will come back with any weakness in stocks.

Recent articles in The Economist and Barron’s, among other business journals, have covered the topic in multiple ways. Several Fed officials have also commented on the possibility of negative interest rates in the United States. They don’t expect it but believe it is a legitimate policy tool. Most importantly, the contingent of negative interest rate believers in the realm of big bond managers is growing.

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I don’t think negative interest rates will land on the shores of the United States, but if you ask me if it could happen, the answer is yes. It’s happening around the globe, and the United States is resistant but not immune to global pressures. Negative interest rates is not something we can ignore, so it’s time to take a look at the subject.

An Incomplete Report Card

The report card for negative interest rates has many incompletes. Switzerland and Sweden dabbled off and on with negative interest rates starting in 2009, but it became the policy of choice at the end 2014.

In the case of Switzerland and Sweden, the move into negative rates was purely a currency measure. Both countries were swamped with investors and citizens dumping the euro for the safe haven of the currencies of Switzerland and Sweden. Negative interest rates were designed to bring down the currency. The economies of Switzerland and Sweden were in good shape, but the central banks feared deflation and ultimate economic harm from overvalued currencies.

The European Central Bank instituted a negative interest rate policy in June 2014 with a minor move on one small reserve account, but the ECB has since expanded the program and is expected to dig the hole even deeper. Japan, having a near 0% interest rate policy for 20 years, went negative in January this year. In the case of the ECB and the Bank of Japan, these were also currency moves but mostly designed to help flagging economies.

Negative interest rates are not new, but there is no long history to look back on, either. Still, we can look at the impact of negative rates that have been observed so far. As covered in the Economist and the widely read John Mauldin newsletter, the impacts of negative rates have been mixed at best. But there are some early signs of disturbing trends.

The most positive result has been the initial reaction in the stock market to rate cuts in the stock market, but those rallies also faded within a short time. Borrowing has not risen perceptibly other than in home financing. The hoped-for surge in borrowing by businesses has not happened. Central bankers are defending the policy, saying it is working but will take more time to be fully realized.

A Major Backfire?

The potential for a major backfire in the policy is coming into view as the behavior of consumers in those countries with negative interest rates is being examined.

Most consumers have swallowed hard and accepted they have to pay to keep their money in banks, but the numbers of consumers taking other actions are growing. Consumers are hoarding cash. At this point the volume of cash being held is not significant but it is growing rapidly. This could be a problem for the European Central Banker. Taking money out of the system will cause even more economic headaches. The bank would not have the money to lend should lending demand increase.

We know the ECB is getting worried about this because the European Union is proposing to end the printing of the 500 euro note. The party line is the note makes it easier for the criminal element to stash and hide cash. Isn’t it funny how that hasn’t been a problem for the past 15 years? Guess there was no crime before then. EU officials deny this is a move to discourage hoarding, but no one is fooled.

It could happen in the United States also. We aren’t in negative rate territory and are not seeing cash hoarding, but it seems there is a move afoot to prepare for that, just in case. Government officials have not brought up the subject, but several economists and think tanks have. They also say it’s to discourage the criminal element. Again, funny how that hasn’t been an issue until the possibility of negative interest rates reared its ugly head.

What else are consumers in Europe and Japan doing? Buying gold. While there has been no shortage of losing assets this year, gold has shone brightly. The yellow metal is up almost 20% from its January low, and I doubt this is an inflation play.

Maybe negative interest rates don’t scare the great minds at global central banks or Wall Street, but it seems to be impacting the behaviors of the common folk. The more negative rates go, the more fearful people become. And consumer polls show European consumers are losing confidence.

Plummeting Profitability

European banks are not coping well. Profitability is plummeting and European banks are under severe pressure from shrinking interest rate margins. Although most of the major money center banks are now charging to hold deposits, most consumer banks are not going negative on consumer deposits. These banks fear once the deposits walk out, they might never come back. So they’re raising fees and keeping loan rates higher. Is this the future for credit unions? It makes me shudder.

Evidence of the benefits to negative rates is minimal at best and outweighed by the potential negative side effects especially on consumers. So why are central banks doing it and why would our Fed ever join the movement?

An Obligation To Tinker

Central bankers don’t feel they can do nothing. They have intervened in the markets and with the plumbing of the financial system for so long, they consider it an obligation to tinker and perform experiments until they realize some magic goal. Moreover, central bankers know they can’t depend on the governments to do what is needed in the areas of structural reform. The attitude is let’s do something, even if it’s wrong!

Even more troubling to ponder is what comes next?What if the world, including the United States, goes negative and it doesn’t work? Not to worry, the great economic think tanks are on it.

Here are just a few of the possibilities that the mad economists are playing with in their labs:

  1. Ban all currency. What better way to make sure consumers don’t hoard cash?
  2. Have the U.S. Treasury issue billions if not trillions directly to the Federal Reserve. The government could use the cash for massive infrastructure projects. Worried about the debt? Not a problem. The Fed could cancel the debt. The U.S. government would keep the Fed in business.
  3. The United States could order all businesses to give raises of 5-10% to all workers and give businesses tax breaks to offset the cost.
  4. The government could simply have the Fed deposit a few thousand dollars in the bank accounts of every adult. Debt? See #2.

These all sound ridiculous and unthinkable, but there are serious men and women studying this. Never forget that Ben Bernanke first started dreaming of zero interest rates and quantitative easing when he was in academia. Sometimes dreams or nightmares can come true.

The Most Dangerous Market In The World

Central bank actions in Japan and Europe have driven interest rates on $7 trillion in sovereign bonds into negative territory. German bonds are negative through seven years, and the Japanese government recently issued 10-year notes at a negative rate. Rates in the United States are still positive but are negative on an inflation-adjusted basis.

The bond market is priced to perfection. There is no margin for error, meaning there is no margin for any economic improvement or increase in inflation expectations. In Europe and Japan, bonds are priced to disaster scenarios.

The world’s major bond fund managers are all in on this trade. The only reason to buy bonds with negative rates is that you expect even more negativity ahead. A gain in principal is the only way to make money.

As a fixed-income strategist for the $125 billion Lord Abbett & Co fund said in a recent Bloomberg article, With negative yielding bonds, you are really in prayer mode for the opportunity to sell to essentially a bigger fool.

You are not yet being put in the position of being the bigger fool, but the U.S. market despite positive yields is just as vulnerable as any global market.

A Good Laugh

I sincerely expect, and hope, this is the last time I write anything about negative interest rates, other than perhaps later this year when I write, What were they thinking? as the funds rate hits 1.50% and the 10-year 3.50%.

We can have a good laugh at that time.

But negative interest rates are a thing now, and I believe in at least giving some thought to what you would do if the once unthinkable thing happened. How would you cope?

Dwight Johnston is the chief economist of the California and Nevada Credit Union Leagues and president of Dwight Johnston Economics. He is the author of a popular commentary site and is a frequent speaker at credit union board planning sessions and industry conferences.

April 7, 2016

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