Interest rates are goin’ down, down, down, down…
Interest rates, as the Boss would say, are goin’ down, down, down, down. However, are the potential outcomes of negative interest rate policy (NIRP) worthwhile? The Economics Team at GSFM’s investment partner, fixed income specialist Payden & Rygel, examines this issue.
Down, down, down is not merely a song lyric. Rates have fallen. It’s not just that rates are low, but in some cases, interest rates have fallen below zero. The global pile of negative-yielding bonds exceeded $17 trillion as of August 2019 (see figure one).
As a result, a lot of ink has been spilled on negative interest rates in recent months. Bloomberg’s story count data show that peak ‘interest’ in negative rates occurred back at the beginning of February 2016, right around the time of the ECB’s fourth cut in its policy rate below zero.
Coincidentally, we first opined on the upside-down world of negative interest rates in the Spring 2016 edition of these pages (see Monetary Policy Unmasked: Our Take On Negative Interest Rates). Our conclusion then: “In the end, we think NIRP will prove counterproductive. Since all monetary policy works through the financial system, central banks need the banks and financial markets to create and distribute credit. Forcing investors, savers, and depositors to divert liquid assets elsewhere will not support credit creation[1].”
Unfortunately, NIRP proved to be no fad. It’s still with us, and hopes for a positive outcome spring eternal. We write here to double down on our NIRP views. NIRP is an ineffective, counterproductive policy. We show that the banking system is the key ‘loser’ in the NIRP era, and a thriving, healthy economy is unlikely absent a robust system of credit intermediation. We then draw lessons from European NIRP for other jurisdictions (i.e. the US).
Just the facts
Let’s put a little context around the bonds that are trading at negative yields. You may be saying to yourself, “the last time I checked, the 10-Year US Treasury yield was nearing 2% again, and even short-term interest rates yield more than 1%!”
Correct.
Most of the negative-yielding bonds (about $12 trillion at the time of writing) are found far from US shores, primarily in Japan and the Eurozone. Japan boasts just over 40% of the world’s sub-zero yielding debt, with France and Germany holding about 15% and 13%, respectively (see figure two).
At times, a few of these countries’ entire yield curves, and thus all their outstanding debt, from zero to 30-year maturities, were below zero.
The overwhelming majority of the bonds with negative yields are government bonds from the developed world, but a few corporate bonds, of varying credit ratings, have dipped below zero, too.
Surely now you’re scratching your head wondering, “Who in their right mind would buy a negative-yielding bond, thereby locking in a negative return if held to maturity?”
And you’d be right to wonder. The math doesn’t add up. Here’s why:
Indeed, there are speculators, hedge funds, and their ilk, buying negative-yielding bonds for the same reason they bought bonds at 1%—a further decline in yields means a higher price over the holding period.
But such buyers are marginal at best. Central banks hold 80% of the negative-yielding debt around the globe (see figure four)[2].
Data is limited, but, based on balance sheet size, yield curves around the world, the types of securities held on central bank balance sheets, and continued monetary intervention, we’d bet the ECB and BOJ are left holding the (majority) of this bag.
Perhaps more interesting is the lack of action from capital market participants at recent bond auctions that came with rather deep negative yields. On August 21, 2019, Germany priced a 30-year bond. The total auction size was estimated at $2 billion with a 0% coupon. Worse, the yield at issuance, which considers the price paid (€103.61 – yikes) for the new issue, was negative (-0.11%).
According to the Bloomberg description page for the security (ISIN:DE0001102481), about €1.2 billion of the deal was retained for “market intervention” purposes. Translation: that was the amount retained by the Bundesbank, the central bank of the Federal Republic of Germany, on behalf of the ECB’s asset purchase program.
Unlike ‘real’ or ‘normal’ investors, central banks don’t buy for income, price appreciation, or total return. Non-economic reasons and explicit policy efforts motivate monetary authority purchases. Subsequent drippings in the press lead us to believe that natural buyers, institutional investors from insurance companies to investment managers, are likely not actively taking down bonds with negative yields in size.
No single class of investors or financial market participants may be feeling the ill effects from negative rates as much as those of European banks (Japanese banks–hold my beer!). Payden’s banking credit analysts highlight the fact that European banks have seen profitability metrics, along with their share prices, deteriorate.
Just look at some of the profitability metrics between Europe and North American (predominantly skewed to US banks). Are negative rates helping European banks? We think the numbers speak for themselves (see figure five).
A recent IMF study focused on the European Union’s banking system profitability concurred. The study linked the lack of recovery in EU banks’ profitability following the global financial crisis to several factors, including the inability to clean up balance sheets of non-performing loans, stricter regulations, and disruption from new technologies. Meanwhile, negative interest rates have pressured interest margins[3].
Pick your favourite profitability metric and run the comparison—European banks appear to be stuck in the mud.
Regulatory frameworks like Basel III (and IV to come) were established to prevent banks from exacerbating funding stress in another financial crisis. While yield curve shape (flat) and negative interest rate policies cause net interest margin deterioration, regulatory requirements to hold increased amounts of high-quality liquid assets at low to negative yields act as another weight on bank profitability. Paying the European Central Bank to hold reserves (unlike US banks, who earn interest on their excess reserves held at the Fed), is not helping[4].
Back in the late summer and early fall, we fielded a lot of calls from clients on negative interest rates and whether those could hit US shores.
What some forget is that we’ve seen negative rates before—though maybe not to the magnitude that our European and Japanese colleagues have experienced more recently. Taking a trip down memory lane, the US experienced negative rates on short-term Treasury bills with various maturities shorter than three months back in September of 2015.
But one may argue that in 2015 there was far too much cash (demand) looking to find a place to invest safely in short-term securities (limited supply). The Fed, possibly to balance supply/demand or to prevent negative interest rates, implemented a reverse repurchase facility, effectively putting a floor under short-term interest rates (at the time at five basis points, or 0.05%).
We’d conclude that domestic policymakers haven’t warmed to negative rates in the US According to the minutes from the October 2019 Federal Open Market Committee meeting, after a briefing on negative rates, “All participants judged that negative interest rates currently did not appear to be an attractive monetary policy tool in the United States<sup[5].”
Moreover, the negative interest rate experiment may be more costly and harder to implement in the US compared to Europe, given the differences in how banks at fund their balance sheets. Most banks in the US utilise a higher amount of deposits to create loans, while, in Europe, banks are less reliant on deposits (due to lower supply of deposits and more fractured geography).
This reliance still appears when looking at loan-to-deposit ratios: European banks are at 103, while US banks are at 84.1[6]. In the US, retail depositors may ask for their money and store it elsewhere.
And, if rates in the US did go negative, there’s a whole host of things that could go wrong in our capital markets and consequences for market participants. For starters, the US money market system would experience even more hardship than it did back in the QE years, and short-term funding sources of capital could go away.
Financial intermediaries that hedge out their interest rate risk via the swaps market, turning fixed-rate assets and liabilities into floating-rate instruments or vice versa, could see some abnormalities in what they thought was a well-constructed hedge. For example, as a corporation, when your “receive leg” is based on an index with a negative interest rate, you could end up paying on both sides of your hedge. Forget worrying about LIBOR, SOFR, and the reference rate language – a broken hedge seems more troubling!
In the end, we don’t know how the NIRP experiment ends. We’re hopeful that the lessons provided by Europe teach global policymakers that the negative rates medicine may be worse than the disease. As of December 2019, Sweden, the first country to ‘go negative’, moved its policy rate back up to zero. A thriving system of credit intermediation is at the heart of economic growth, and policies that threaten the profitability of institutions at the heart of credit intermediation are unlikely to achieve their goal.
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