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What We’re Reading This Week

Negative Rates

This week Alan Greenspan told CNBC, when speaking of negative interest rates, “It’s only a matter of time before it’s more in the United States.”

This comment is more chilling today than it has even been as developed nations adopt negative rate policies. Indeed, only the U.S., Canada, Australia, and New Zealand have negative rate-free bond markets. Likewise, the current administration has continuously advocated for rate cutting to fuel economic growth.

First, it’s important to draw the distinction between negative yield and negative rates. Negative rates can lead to negative yields but it doesn’t really work the other way – meaning negative yields can result from market forces, while negative rates only result from policy.

Negative yields occur when the price of debt exceeds its face value, thereby reducing its coupon. For example, a $10,000 debt issue could have a coupon of 4%. As an investor, you lend $10,000 to a corporation or a municipality, and in return it pays you $400 a year for a specified period of time and returns your $10,000 to you at the end of the term. Debt instruments like this also trade on the open market, so depending on how valuable that coupon is, someone could pay more or less than $10,000 for the bond. If the bond were to cost $9,000, your effective yield becomes 7.8%, instead of 4%. This is because in addition to the $400 you received each year, you’d also receive the full $10,000 at the end of the term. Right now, rates are incredibly low, and as more baby boomers retire and look for financial stability, bonds will be in high demand. With the prospect of rising interest rates in the future, longer term debt will be eschewed in favor of short-term debt, which almost exclusively trades on the secondary market (at a discount or premium). A $10,000 debt issue with a 4% coupon only needs to cost $11,500 to turn the effective yield to -.92%.

Conversely, negative rates (which can drive negative yield further) occur when the central bank cuts rates below 0%. In the U.S., the rate to watch is the 30-year treasury, currently at 1.95%. This isn’t much lower than the current bank reserve rate of 2.1% and the fed funds rate of 2.25%. Should bank reserve rates turn negative, it’s very hard to say how it will affect the economy. Theoretically, negative rates are meant to incentivize banks to lend more and push consumers to spend. Why build up reserves when you are penalized to do so? In theory this is great, but as we have seen in Japan and Europe, there can be unintended consequences. Lending has been muted overseas as bank profits have been eroded by negative rates. Banks don’t lend when they don’t make money.


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Categories: Industry Ideas, News, The Market