Ultra-low or negative interest rates: what they mean for financial stability and growth

Assiduous Readers will remember that I was recently quoted as saying:

“It is simply not sustainable for a five-year Canada to trade below inflation forever,” he said. “That simply cannot go on.”

I have been challenged to substantiate this assertion and my immediate response was:

You are correct – it’s because the real yield is not just negative, but significantly negative.

Some bond investors have to put up with this kind of thing; banks, for instance, are required to hold a large quantity of government bonds. Central banks will, in general, place a very high premium on liquidity, since when they want to trade they want do it in size and they also place a high premium on the ability to transact at the height of a crisis.

But the marginal investor will eventually get tired of losing money on a real basis while tying up their money for five years. In addition, the marginal borrower will step up borrowing because he’s getting paid – in real terms – to do so. We are already seeing significant economic distortions resulting from these marginal borrowers because instead of buying productive assets, they’re buying houses in Toronto and Vancouver … eventually, all the stresses will be relieved, and there will be a positive real yield on five year Canadas … either because government yields go up or because we enter a period of deflation.

These will be familiar themes to Assiduous Readers; the requirement for banks to own an increasing number of sovereign bonds for highly politicized (and economically illiterate and fiscally expedient) reasons was discussed on September 4, for instance.

While poking around for more authoritative and crushing retorts, I came across Remarks by Hervé Hannoun, Deputy General Manager, Bank for International Settlements, at the Eurofi High-Level Seminar, Riga, 22 April 2015, titled Ultra-low or negative interest rates: what they mean for financial stability and growth. He was mainly concerned with the European situation:

When policy interest rates came down to almost zero and central bank balance sheets expanded due to large-scale market interventions in the wake of the Global Financial Crisis, the consensus was that this unconventional monetary policy (UMP) would be temporary. More than six years later, the prospect of normalisation seems remote in most advanced economies. Indeed, most of continental Europe (the euro zone, Denmark, Sweden and Switzerland) have moved towards a much more extreme form of UMP by introducing negative policy interest rates, and/or negative central bank deposit rates. Together with forward guidance and large scale asset purchases, such measures have created an unprecedented situation where nominal interest rates in a number of European countries are negative across a range of maturities in the benchmark yield curve, from overnight out to five years.

There is no precedent in economic history for negative nominal interest rates, even during the Great Depression in the United States.[Footnote] Not even Keynes, who coined the terrifying metaphor of the “euthanasia of the rentiers”, ever contemplated negative nominal interest rates. An experiment is under way in continental Europe to test the “boundaries of the unthinkable” in monetary policy.

[Footnote reads] In the wake of the Great Depression, US short-term nominal interest rates fell to near-zero levels in 1932 but they never turned negative.

He shouldn’t be quite so absolute in his footnotes! There were brief episodes of negative US bill rates in 2013:

Treasury bills that mature as soon as November traded below zero today [2013-9-26], with the bill maturing on Nov. 29 having a negative 0.005 percent rate at 2:02 p.m. New York time. The three-month bill rate was negative 0.0051 percent, compared to 0.0152 percent yesterday. Treasury bills that mature on Oct. 24 were at a rate of 0.038 percent, up from 0.018 percent yesterday.

and in 2014:

A scramble for safe, short-term debt left some investors on Tuesday paying for the privilege of lending to the U.S. government.

The demand, which intensified following the Federal Reserve’s decision this month to curb a popular overnight-lending program, pushed up bond prices and drove down yields. The yield on the U.S. Treasury bill maturing on Oct. 2 traded at negative-0.01%, according to Tradeweb, the first negative yield in eight months. Yields on other Treasury bills due in three months or less hovered around zero.

Short-term debt trading at negative yields was essentially unheard of before the 2008 financial crisis. But since then, the condition has cropped up at times of market stress, reflecting extraordinarily expansive central-bank policy and anemic growth in much of the world. Yields on some U.S. bills traded below zero at the end of each of the past three years amid strong demand for liquid assets, according to analysts.

and shortly after the speech:

For all the anxiety over the global selloff in bonds, the big worry in money markets is the havoc being created by a dearth of U.S. Treasury bills.

The magnitude of the problem was on display last week, when not even the Treasury Department’s surprise announcement to boost sales could do much to lift bill rates. Over the past two weeks, some of those rates have turned negative, reaching levels last seen during the financial crisis.

With supply at multi-decade lows, investors are signaling alarm as regulations intended to shore up banks and prevent a run on money-market funds exacerbate the bill shortfall. JPMorgan Chase & Co. expects an extra $900 billion of demand for government securities during the next 18 months, putting pressure on a sizable chunk of the $1.4 trillion bill market.

The mismatch between supply and demand has been so acute that four-week bill rates fell to minus 0.0304 percent on April 29, the lowest on a closing basis since December 2008. Yields on three-month bills also turned negative. The Treasury responded by saying at its quarterly refunding announcement on May 6 it would increase issuance to meet growing demand.

… and in the US in the Great Depression:

1The interest rate on Treasury bills would tend to not fall below zero if currency incurs no taxes, storage costs, or insurance costs. Absent such costs, if the Treasury bill rate were to be negative the holders of Treasury bills would prefer to hold currency because currency has the advantage of being a more liquid asset and its implicit interest rate of zero would be greater than the negative rate on Treasury bills. Holders of Treasury bills would sell them, drive down their price, and increase their interest rate until the interest rate reaches at least zero. For simplicity, we assume the lower bound on short-term interest rates is zero, even though nominal yields dropped slightly below zero in the United States in the Great Depression (as discussed in footnote 15) and in Japan recently (as discussed in footnote 22).

15See Federal Reserve Board (1943, p. 462). Two reasons for this phenomenon, perhaps responsible for a few basis points of the negative yield on Treasury bills, are as follows: First, Treasury bills were exempt from personal property taxes in some states, while cash was not. Thus, the after-tax rate of return on cash holdings was negative in some states. Second, Treasury securities were required as collateral for a bank to hold U.S. government deposits, so the total return, net of the collateral benefits, could have been zero or positive for banks. During this period, negative yields were also reported on Treasury bonds with up to two years maturity, owing to a valuable exchange privilege implicit in holding the securities. Cecchetti (1988) provides a detailed explanation of this phenomenon and shows that once the value of this exchange privilege is accounted for, yield estimates on those securities become positive. These factors allowing for negative pecuniary yields emphasize that institutional considerations such as these make it dicult to be precise about the actual lower bound for nominal interest rates.

But let’s be fair … perhaps Mr. Hannoun meant “short-term bonds” when he said “short-term” and perhaps he is not so much of a pedant as to specify “after accounting for special privileges”. Still, he could quite easily have said “rare and transient”.

At any rate, Mr. Hannoun first reviewed the effects of low interest rates on growth:

In essence, the monetary stimulus aims to lift short-term growth via five main channels: by boosting credit to the real economy (the credit channel), by lifting asset prices (the asset valuation channel), by forcing investors away from safe assets towards riskier ones (the portfolio balance and risktaking channels), by lowering the exchange rate (the exchange rate channel) and by attempting to nudge inflation up towards objectives with a view to warding off a so-called deflationary spiral (the reflation channel).

It’s all good stuff, but one thing worth highlighting is his discussion of the portfolio balance and risk-taking channel:

Advocates of UMP argue that these policies will encourage investors to shift out of government bonds and into riskier assets. This is the portfolio balance channel. Indeed, the search for yield engineered by zero or negative nominal policy interest rates has fuelled more risk-taking, leading to a convergence between the returns of risky assets and those of low-risk assets, as currently seen in the euro zone’s sovereign credit spreads. These appear to be re-enacting the extreme compression of sovereign spreads, invariant to differences in credit quality, that occurred before the crisis (Graph 2). If, as many would agree, the euro zone’s sovereign risks were mispriced then, we now seem to be heading back to that situation. The European Commission’s prudential policy of applying a uniform zero risk weight to all sovereigns in EU bank regulation strengthens this effect. The problem here is that risk weights are not differentiated according to credit quality, contrary to the Basel II requirements.

In reaction to negative yields in the short- and medium-term segment of the euro zone sovereign yield curves, investors are piling up interest rate risk by investing in long-dated securities at very low yields. And, in fact, the effective duration of euro-denominated debt has risen significantly since the second half of 2014 (Graph 3). As a result, an eventual normalisation of long-term yields would inflict significant and widespread losses on investors, with potentially serious consequences for financial and economic stability.

This makes it a matter of urgency to address the gap in global regulation on interest rate risk in the banking book. Pillar 1 currently does not provide for any capital charge against this risk, an anomaly that will, we hope, soon be corrected by the Basel Committee on Banking Supervision (BCBS). As monetary policymakers, central banks in Europe have contributed heavily to the build-up of duration risk by bringing nominal yields in the two- to five-year part of the yield curve down to near zero and even negative levels. As supervisors or systemic risk managers, they should ensure that commercial banks are allocating enough capital to cover the interest rate risk they are accumulating. All this puts a premium on introducing a Pillar 1 charge on interest rate risk in the banking book as soon as possible.

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However, I’m more interested in the section titled Longer-term unintended consequences of ultra-low or negative
interest rates (emphasis added):

From a longer-term perspective, there are five main risks that may make the prolongation of ultra-low or negative nominal interest rates counterproductive. These can be summarised as: disincentive, distraction, distortion, disruption and disillusion.

Bond market prices in the euro zone may no longer adequately reflect the risk inherent in record high debt levels. At the same time, equity prices are artificially inflated as investors are forced into increasingly risky assets. All this involves the risk of a major correction when confidence in inflated valuations is lost. The question is not whether this will happen again, but when. Of course, nobody can say when the next “Minsky moment”, a generalised loss of confidence in artificially inflated valuations, will occur. Yet there is no doubt that the probability and severity of another financial crisis is increased by the prolongation of ultra-low or negative rates.

Advocates of ultra-low or negative interest rates argue that macroprudential tools can be used to offset/mitigate the financial risks and distortions resulting from ultra-easy monetary policy.

The risk of disillusion also looms large for households in the new world of low returns. Ultra-low or negative interest rates will add to their worries by making it difficult for them to build up enough retirement savings. Thus households are more likely to increase their savings rate than to reduce it.

Negative rates on deposited savings – effectively a form of taxation – will feed the debate on the
“financial repression” of savers.

True, some households stand to gain from low mortgage rates, but this benefit will accrue only to those who can afford to buy a house. Moreover, the positive effect of low mortgage loan rates is largely offset by the increase in property prices fuelled by ultra-low interest rates.

There is also the question of inequality. Most households will lose from the dwindling returns on their savings without gaining anything from asset price inflation. They are not sophisticated asset managers who can realise capital gains in financial markets when long-term yields fall, and they will be affected by the low returns on their savings.

It will be noted that the word “macroprudential” is basically the new cool way to say “credit rationing”:

In the UK the Bank of England has been flashing an amber light for months about the complacency shown by low market volatility, but in house-price obsessed Britain, mortgage excess is the focus of its worry. Last month it became the first of the major central banks to set out to try to control credit using non-monetary tools: in the jargon, “macroprudential measures”. Ms Yellen has been highlighting macropru as the first line of defence against bubbles for a while.

The problem is simple. Central bankers want money to lubricate the real economy, not to flow into pointless leverage of existing assets. Higher rates could reduce the incentives to leverage, but at the cost of damage to the real economy. Their solution is to set up barriers inside the banks to direct the flow.

As financial historian and CLSA consultant Russell Napier pointed out recently, credit rationing was a disaster in the 1970s. The theory relies on markets being so bad at allocating resources that the job is better done by a handful of men and women at central banks and regulators.

We’ve seen some of this credit rationing in Canada, of course, in the tightening of mortgage requirements by the CMHC and bank regulators; wildly cheered on by established Canadians who inherited their house from Mommy and Daddy and don’t like the idea that immigrants and the working class might get a shot at ownership.

Mr. Hannoun concludes:

The policy of prolonged ultra-low, or negative, interest rates relies on transmission channels with uncertain effectiveness and potentially serious unintended consequences. For central banks, such policies raise the risk of financial dominance, exchange rate dominance and fiscal dominance – that is, the danger that monetary policy becomes subordinated to the demands of propping up financial markets, massaging the exchange rate downwards, and keeping public refinancing costs low in the face of unprecedented public debt burdens. These risks have been present before,13 but never so acutely as today.

Meanwhile, financial markets continue to set the stage for policy deliberations by fuelling expectations for continued, and additional, monetary accommodation. Behind the enthusiasm of market participants for extreme monetary policy, of course, lurks the fear that asset prices might collapse when the music of monetary easing stops.

So, yeah, this speech belongs in a list of justifications for my statement!

3 Responses to “Ultra-low or negative interest rates: what they mean for financial stability and growth”

  1. externality says:

    Great post.

    On my experience, the people who are already own houses aren’t put off by idea of others wanting to buy or even govt subsidy for those wanting to buy. As far as they are concerned, it’s all extra demand. What they are really put off by, is more supply. Especially, any move toward a real free market where perhaps an enterprising neighbour might decide to take advantage of that demand by building a cottage, accessory suite, or heaven forbid, a duplex. Thankfully for them, zoning laws make this cheap and easy way of providing new supply illegal for most property owners. All hail the free market!

  2. sglandon says:

    How would resets be treated if 5 yr. goc bonds go negative?

  3. jiHymas says:

    On my experience, the people who are already own houses aren’t put off by idea of others wanting to buy or even govt subsidy for those wanting to buy.

    A lot of my impression comes from the on-line comments to Globe & Mail articles whenever the topic of mortgage guarantees comes up. Woo-hoo! You’ve never heard such a pack of fiscal Puritans!

    Thankfully for them, zoning laws make this cheap and easy way of providing new supply illegal for most property owners. All hail the free market!

    Every time I eat in a restaurant on the Danforth I have to spend ten minutes in advance telling myself to be calm. It breaks my heart every time, seeing this enormous stretch of prime land, on an arterial road, serviced by a subway that has been in existence for fifty years … with damn few buildings over three stories on it.

    How would resets be treated if 5 yr. goc bonds go negative?

    This is a question that has arisen in previous comments.

    If the strict terms of the prospectus are applied, I would expect that the negative yield would be added to the positive spread and the result applied: e.g., if GOC5 is at -0.50% and the spread is +200bp, then the yield paid would be 1.50%.

    In practice … I don’t know. It’s something that has not previously been contemplated and there are various views on what might happen in Europe. Whatever happens, the lawyers will get paid!

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