The Risk Of Negative Interest Rates In The U.S.
By Robert A. McCormick
“There is no barrier for U.S. Treasury yields going below zero. Zero has no meaning, besides being a certain level.” – Alan Greenspan, August 13, 2019
This statement epitomizes August in a nutshell. It was an exhausting month for investors.
The stock market was volatile and down in August, in part because the trade war with China heated up. Additionally, the Fed sent mixed signals about future interest rate changes. In the Fed’s defense, why wouldn’t it send conflicting signals? The Fed is likely as confused as the rest of us given the trade uncertainty with China and the talk of negative rates coming to our shores.
Ex-Fed Chairman Greenspan may be correct in that Treasury rates could ultimately fall below zero in the future. But implying it would have no meaning is definitely unusual. It is helpful to examine the possibility of negative interest rates in context:
- Brief spurts of negative yields first appeared during the panic days of late 2008. They became “institutionalized” a few years later by central banks outside the U.S. The European Central Bank dropped deposit rates to banks below zero in 2014 and the Bank of Japan followed suit.
- Fast forward to today and the negative rate “contagion” has spread way beyond central bank efforts to avoid deflation by incentivizing commercial banks to make loans. There is now nearly $17 trillion of international debt trading at interest rates below zero. If you buy and hold these bonds to maturity, you are guaranteed a negative return. And if there is inflation in the future, your real return is even deeper into the red.
- While most negative rate bonds are government bonds, corporate bonds now make up a large amount. Investors are willingly locking in a negative return on bonds that carry credit and liquidity risks. That’s not just unusual, it’s downright scary.
- All of this is unprecedented, as seen in the chart below (ending in 2014) from Merrill Lynch. Over the past 5,000 years, there is no other recorded era of lenders paying borrowers to borrow money (ignoring the obvious short-term bank accounts used as a source of ready cash).
Investors are trying to make sense of this new abnormal. Justifications offered include:
1) Anticipating future deflation with no real economic growth;
2) Investing for currency gains while accepting the interest return will be negative;
3) Speculating rates will continue their negative trajectory because that has been the trend – reasoning it is still a profitable bet. Also, as more bonds go negative, downward pressure is applied to the bonds with positive yields, driving their yields toward zero and beyond;
4) Hypothesizing that, all of a sudden, an aging society with plentiful savings are enough to convince investors a positive return is no longer important. This argumentis the most controversial – and alarming. It eradicates the most basic law of finance: there is a time value of money – the idea that a dollar in your pocket today is more valuable to you than that same dollar in your pocket a year from now.
None of these reasons taken on their own adequately describe what is happening. And, some of these reasons lack hard evidence that they are credible. Maybe all are part of the unsolved equation as to why nearly 1/4 of the world’s bond supply trades at yields below zero.
Or maybe it’s just another crazy bubble, like placing a higher value on the Imperial Palace of Tokyo (280 acres) than all the real estate in California.
At present, the U.S. has avoided life below zero. It is a meaningful barrier and one we don’t want to breach.
Stocks were weak in August, both in the U.S. and abroad. Bonds were strong due to a sharp drop in most interest rates. Interest rates on U.S. Treasury bonds maturing in 10 years and longer dropped by over 1/2% during the month. Over the past 12 months, bonds have outperformed stocks.
Robert A. McCormick, CFA, CAIA