The Return of Negative Interest Rates

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The Return of Negative Interest Rates

There is a spectre haunting the global economy — the spectre of negative interest rates! Puns aside, if you have been following the financial new as of late, the global economy is in a very sensitive state where many are predicting another collapse in the near future (relax — someone is also predicting collapse).

The primary reasons for these concerns have been, amongst the cadre of developed nations most looked at for the “pulse” of the global economy (read: OECD countries): slagging economic growth rates; plummeting crude oil prices; a struggling stock market; slow moving inflation rates; China’s recent recessionary numbers and their inability to control it; and, most notably, a growing number of economies experimenting with negative interest rates on government bonds. While the number of economies with explicit negative yields on government securities is still small, the remaining economies are either at zero or slowly approaching it. Here in the United States, many not only fear that the Fed will fail to increase rates four more times within this year (as they declared previously) but may actually reverse their December decision and decrease rates back to zero.

Before going into fine details of the situation, it is worth noting the link between government bonds and interest rates. Governments — yes, almost all of them — spend more than the aggregate collection of tax revenues and need to finance their budgets. The common way to achieve this is to issue out debt securities known as discount bonds. As an example, the U.S. Treasury may sell a bond worth $1,000 (known as its face-value) for $900 with the understanding that it will buy the bond back at an agreed date (say, in a year) for $1,000. The government gets its much-needed cash ASAP and the investor walks away with a $100 profit, or an 11% return on investment. This return on investment is the interest rate on the bond. Given that the U.S. Government has zero risk of default (it can print more money or raise taxes to pay its debts; hence, the importance of debt ceiling increases), firms selling securities have to offer a rate at or around the government rate to attract lenders. This, in a very (VERY) simple way, is how central banks manage interest rates throughout the economy.

So what is the issue with negative interest rates? Like any negative price, negative interest rates make economists a tad uncomfortable. In essence, any negative price means that suppliers/producers are paying consumers to take their product(s). How would you feel if someone came to you on the street and offered to pay you $10 to take his/her coffee off their hands? Hopefully, most readers would at the very least be skeptical of the transaction. Yet this is exactly what having a negative interest rate on a government or corporate bond implies: lenders, or the buyers of bonds, are paying the borrower to take their money. In other words, investors are paying for the “honor and privilege” to lend their money to the government. Alternative investment opportunities have to be pretty bleak for this to take place . . . and that is exactly the issue.

The other problem with negative interest rates is that it goes against its fundamental nature. Interest rates on loans are used to help monetize risk. If I could loan you $1,000 today with complete certainty that (a) you would pay me back the loan in full by a specified date, say in a year, and (b) I would not need that money for any reason while it has been loaned out to you, then the interest rate would be at or very close to zero. But such certainty can only come with complete and perfect knowledge of the past, present and future. Since no one but God is privy to such information, uncertainty and risk must always present. If zero risk leads to zero interest, then what does a negative interest rate really mean? To paraphrase the (in)famous hedge fund manager Michael Burry, negative yields are an indication that our entire mechanism for monetizing risk is broken.

Not a pleasant thought, to say the least.

Even so, there have arisen a number of central bankers and academics that support the idea of setting interest rates below zero. To understand their thinking, let us summarize the argument of the pro-negative-rates cam. With slagging economic growth rates, central banks want to increase spending and investing. The classic solution (at least in the short run) is to increase borrowing by dissuading savings through lowering interest rates. Great, right? Well, there are a couple of problems. For one, interest rates are at or so close to zero that the standard weaponry of monetary policy is out of ammunition. Worse, many of the developed economies are now experiencing levels of deflation; that is, the prices of all goods and services in the economy are, generally, getting lower. Because prices are decreasing, so will revenues, wages and incomes. As a result, it will be harder for firms and households to pay off their loans (remember that loan principals do not adjust for inflation/deflation) and the “real cost of borrowing”, known as the real interest rate, has increased. What’s a central banker to do? The only avenue left for them to do: go into the negative.

To be fair, this is not our first encounter with negative rates. The most famous case in recent history was Japan during the late-1990s/early-2000s. Due to a mix of historically high levels of saving, a prolonged recession and a serious bout with deflation, the Japanese central bank set government bond rates into the red. The concern was not necessarily the negative rates themselves but what they said about the economy as a whole: trouble, trouble and some more trouble. Serendipitously, it is the Bank of Japan’s recent embrace of negative interest rates that has once again alerted the financial community that a series of unfortunate events could be taking place.

Japan is not the only economy to experiment with negative rates and, truthfully, it’s a new entrant into this game. By all accounts, Switzerland, Denmark and Sweden (the home of the oldest existing central bank, the Riksbank) were the first to start this recent trend. In fact, leaders at the Bank of England also echoed the possible benefits of negative government bond yields. But there is a couple of differences between the situation in Japan and that of the other economies.

First, while Switzerland, Denmark and Sweden set negative interest rates on short-term to intermediate-term bonds, Japan has now issued a 10-year bond at a -0.1% interest rate; that is, Japan has been the first to set a negative interest rate on long-term bond. Long-term bonds are riskier than their short-term (maturity of less than a year) equivalents to begin with. Adding a negative yield decreases the bonds attractiveness even further . . . and investors are still buying them!

Second, as opposed to the above-mentioned economies, Japan did not really aim to be in this position. In fact, it is the result of a failed economy-boosting strategy. To push investors out of the government bond market — where most dump their money for safekeeping while they search for better alternatives — the Bank of Japan began an aggressive bond buying operation. The aim was to get investors active in other markets, such as stocks and commodities. Unfortunately, those markets became so unstable that even with decreasing interest rates, investors stuck to purchasing Bank of Japan bonds. With the decreased supply and, consequentially, increased demand of these bonds, the interest rates fell below zero.

Finally, if negative interest rates on bonds are so horrible, why are investors buying them? Beyond the commercial banks and various companies that are required to keep government bonds as reserves, many investors are still purchasing these bonds for one main reason: they are still safer than the current and very much volatile stock market. And this is, again, the real problem with the whole situation. The uncertainty in equity markets has risen so significantly that investors are paying the government to protect their money from shear disaster. Whether an economic disaster is truly looming around the corner or not, the global economy has a lot of soul searching to do.

But, as per usual, Allah knows best.

Crisis On Infinite Markets: What the bleep is going on in the economy?

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Crisis On Infinite Markets: What the bleep is going on in the economy?

By Dr. Jerry Hionis

The famed Keynesian economist Sir John Hicks once quipped, “Investment is a flighty bird”. What Hicks meant by this statement is that stock markets, bond markets and the investors involved wherein are almost impossible to truly predict. Further, investors are a particularly finicky bunch; suffering from a self-protective heard mentality that Keynes himself labeled animal spirits. Many stock markets boom and bust merely from the collective “feeling” of investors and rarely from data driven analyses.

After what is now being labeled the Great Recession of 2007/2008, the U.S. economy has been heading back into an expansionary period where all economic indicators (baring the growing wealth and income gaps) are looking quite positive. Yet the stock market took a couple of big dives at the end of August, causing a wide range of panic levels from the academically astute to the economic laity. And while I may spend my days roaming the halls of the preverbal ivory tower of academia (my office building does have a castle-like tower design), the average Joe’s questions about the economy have yet to subside: What is the state of the economy? What is the deal with China lately? Did the stock market collapse? Should I be worried about by savings account? What about my 401K and IRA?

Therefore, in my (never ending) quest to help service the economic queries of the community, I want to present a bit of background as to, as one acquaintance put it, “what the bleep is going on in the economy”?! Continue reading

Making Decisions As A Family

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Making Decisions As A Family

By Jerry Hionis

Economics is a study of human decision-making. The dominant philosophical view of economics, the classical/neoclassical school, has had a historical focus on the homo economicus; that is, the “economic man”. What this means is that decision-making is largely done from the point of view of an individual: with any action, how do the results of said action affect the happiness and suffering of that individual?

Yet this is not always the case. People do not just act as individuals but also as individuals within groups; individuals within groups within groups; individuals within groups within groups within . . . you get the picture. We each are members of various social groupings: families, geographical entities, nationalities, ethnicities, occupations, political blocs and so on. Out of all the various social groupings one can be apart of, the “family unit” is considered to be one of the most important. Given its importance, it should be to no surprise that the family — and, invariably, how it should be run — is highly controversial. Continue reading

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