Negative Interest Rates in the U.S.: Are We There Yet?
(September 9, 2019) – A negative interest rate on a U.S. Treasury bond—try to wrap your head around that one. You fork over $100 to buy a 10-year Treasury bond, an investment instrument backed by the full faith and credit of the United States of America, and a decade later, when the bond matures, you get back $94. Think about that; by buying and holding this bond, you’re essentially paying the U.S. government a fee to store your money. Really?
Really. Just ask anyone who recently purchased a 10-year German government bond, whose yield in August 2019 stood at -0.675%. Moreover, on August 20, Germany sold 834 million euros of 30-year debt that will require the government to pay back 795 million euros when the bonds mature in 2050. This action continues a global trend that now entails about $16 trillion of negative-yielding sovereign debt, or roughly 25% of the market.
Despite U.S. interest rates already at or near historic lows, worries that the global economy is slowing and that trade wars will take a bigger toll on growth have led fixed-income investors to jump even further into the safety of bonds, resulting in a steep slide in U.S. government bond yields that left some pondering what was once unthinkable: is there a likelihood U.S. Treasury yields will go negative?
Negative Interest Rates: How Did We Get Here?
Switzerland was the first sovereign government to charge a negative interest rate.[1] It did so between 1972 and 1978. Why? The country’s central bank imposed a negative interest rate to help stabilize the economy and to prevent its currency from rising too much from foreign investors buying its currency. A rising currency is not a good thing. What this means is that the Swiss currency was losing purchasing power as compared to other currencies. As of August 2016, 1 US dollar is worth 0.97 Swiss francs. Now, if the Swiss currency rose, it might mean that 1 US dollar is now worth 2 Swiss francs. Think about what this means. If you had Swiss currency and you wanted to buy a shirt costing $10 US dollars, instead of paying 9.68 Swiss francs, you now have to pay 20 Swiss francs because the currency rose.
When currencies rise, it means that the economy of the country is not doing too well. So, in order to help spur the economy, the central bank of Switzerland started using negative interest rates in hopes of encouraging its commercial bank account holders to lend its money out to people instead of keeping it in the central bank reserves. When a central bank has a negative interest rate, it means that commercial banks must pay a fee whenever they deposit money into the central bank’s reserves. Banks can avoid this if they give out loans to people or invest its own money into the economy.
For similar reasons, the central bank of Sweden in 2009 and Denmark in 2010 also started charging negative interest rates. Those countries wanted to help their own economies and they hoped that with a negative interest rate at the central bank, commercial banks would be willing to lend to more people, thus strengthening the economy.
In 2014, the European Central Bank (ECB) instituted a negative interest rate that only applied to bank deposits intended to prevent the Eurozone from falling into a deflationary spiral.[2]
European Debt: The Deep End of the Negative Interest Rate Pool
At present, four European countries — Denmark, Germany, Netherlands and Finland — have negative yields across their full spectrum of rates. In addition, yields for 30-year government bonds have fallen below 1% in the U.K., Portugal and Spain. Fostering this move has been dwindling expectations for inflation and growth. Investors, analysts and economists have come up with a variety of explanations for why European economic growth has been so sluggish over the past decade. Those include the historic levels of debt held by governments and businesses, which some argue has curtailed investment. There are also explanations for why inflation has failed to take off even after a decade of growth. These include technological developments and global supply chains that have held down the cost of producing goods.
European central banks up have been relying mainly on various forms of quasi-fiscal policy to boost their economies, but the weight of evidence suggests these are far less effective than normal interest rate policy. Often lost in the discussion is the fact European central banks are essentially wholly owned subsidiaries of their respective central government. For example, when central banks purchase long-term government bonds by issuing bank reserves that match the short-term treasury bill rate, this amounts to no more than shortening the maturity structure of the consolidated government balance sheet. Treasuries do this routinely and are perfectly capable of handling it on their own and on scale. In general, the fiscal authorities have ample tools to accomplish (or undo) any quasi-fiscal actions that central banks might take. They have access to greater resources and certainly have greater political legitimacy. The quasi-fiscal powers of the central bank are essential only in crisis situations where the ability to move quickly trumps other considerations. To paraphrase former US Treasury Secretary Hank Paulson, when interest rates are at or near zero, central banks needs a “bazooka” that makes credible its commitment to achieving its policy rule.[3]
Which begs the question: who is buying these bonds? The European Central Bank, for one. They have been a big buyer of German government bonds as part of their foreign exchange reserves. Insurance companies, which need to hold bonds as part of their reserves. Pension funds, which own bonds to match their liabilities. And commercial banks, which need government bonds to meet liquidity requirements and also to pledge as collateral when they borrow in the money markets.
Then there is the “race to the bottom” thesis. Because bond prices rise as yields fall, investors can make money if rates continue to drop. In an extremely low yield or negative interest rate world, investors hope for price appreciation on instruments where they had once looked for yield. “Why are people buying at negative yields? It is mainly in expectation that you’re going to be able to sell to someone at a higher price later on,” said Andrea Iannelli, investment director, fixed income at Fidelity International. “Whatever the yield, you have to assume you’re going to make more on the capital gain than lose on the yield.”[4]
European Banks: Is it Time to Bite the Bullet?
Recent data suggests negative yielding debt has yet to lead to a true revival in most European economies. They have also hurt savers and threatened the financial system by curtailing the ability of banks to generate profits. Ever since negative yields became a thing, banks have been too afraid to pass them on to retail depositors. That may be about to change.
In Scandinavia, where sub-zero rates have been the norm longer than most other places, the finance industry has undergone several drastic adjustments to survive the regime. Banks have relied more on asset management and other services that generate fees, and less on the traditional business of lending and holding deposits. But with no end to negative rates in sight, those changes may not be enough. [5]
The director of the Danish Bankers’ Association, Ulrik Nodgaard, says shielding retail depositors from negative rates means that “banks are selling their products below cost price.” Jesper Berg, the head of the Danish Financial Supervisory Authority (FSA) in Copenhagen, says that so far banks haven’t passed negative rates on to private customers for “political reasons.” But if they finally do, “it will be interesting to see whether customers would accept that or vote with their feet” and withdraw their savings.[6]
Banks have so far balked at the idea. The first lender to charge depositors risks losing them, and any industry agreement to coordinate a move would expose banks to cartel charges. At Danske Bank A/S, spokesman Claes Lautrup Cunliffe recently underscored the sentiment, saying it does “not plan to introduce negative rates to private customers, even wealth customers.” Berg at the Danish FSA says the there’s now a “higher risk” that retail customers would walk out on any bank that forces them to share the cost of negative rates.
But some European banks are already biting the bullet. In Switzerland, UBS Group AG recently decided to charge wealthy clients on deposits that exceed 500,000 euros ($560,000), in addition to introducing negative rates for clients holding large Swiss franc balances. Credit Suisse has said it will impose a fee on customers holding more than 1 million euros.
Lower Interest Rates: A Strategy to Weaken the U.S. Dollar
A critical weapon of any central bank’s monetary policy arsenal is to lower interest rates to spur economic growth. A side effect of this quantitative easing strategy is the weakening of that country’s currency. In theory at least, a weaker currency should lead to a boost in demand for exports, thus strengthening the economy.
This strategy has been employed by Japan since the mid-1990’s, when the crash of its commercial real estate market led to a sustained period of ultra-low inflation, and in some instances deflation, associated with weak economic growth. However, twenty years of following this strategy failed to lift consumer prices, so in 2016 the Bank of Japan announced that it would begin charging commercial banks a fee of 0.1% on a portion of their reserves they keep with it.[7] Negative interest rates in Japan had finally arrived.
But as the Japanese example suggests, what alternatives does a central bank have to boost its economy when borrowing rates are already low? Such is the quandary facing the United States Federal Reserve. Less than a year ago, the Federal Reserve was hiking short-term interest rates, and investors were betting that yields—which rise when bond prices fall—on longer-term debt would continue climbing as U.S. growth showed signs of accelerating and as unemployment plumbed historic lows. But signs of economic slowdown, and arguably political pressure exerted by President Donald Trump, caused the Fed to reverse course with a 25-basis point cut in July 2019. Yet despite that action the U.S. dollar remains strong vis-à-vis its high interest rate environment compared to the rest of the developed world, prompting President Trump to tweet on August 21;
“So Germany is paying Zero interest and is being paid to borrow money, while the U.S., a far stronger and more important credit, is paying interest and just stopped (I hope!) Quantitative Tightening. Strongest Dollar in History, very tough on exports. No Inflation…WHERE IS THE FEDERAL RESERVE?”
Trump maintains that the Federal Reserve should lower rates even further, in part to weaken the dollar and spark an increase in export activity to keep the ten-year economic recovery from stalling. But with 10-year and 30-year Treasuries presently yielding approximately 1.45% and 1.95%, respectively, how much lower can the Fed go?
And what if the Fed does lower rates and the rest of the world follows suit to maintain their currency advantage? “I think the momentum trade is basically saying to the Fed: ‘You’re falling behind the curve.’ The Fed does need to keep up with what’s going on in global markets. The one barometer we have to look at, to make it simple, is the dollar. The stronger the dollar gets, the more negative it is for the global economy,” said Jim Caron, portfolio manager at Morgan Stanley Investment Management. “A lot of the world’s debt is in dollars. The slower the Fed goes, the stronger the dollar gets.”[8]
The Case for Borrowing More “Free” Money
Imagine this scenario: your salary is $10,000 a month, and the principal and interest on your 30-year mortgage totals $2,500. Your monthly mortgage obligation equals 25% of your income. You want to take out a second 30-year mortgage with similar rates and terms, but that would raise your mortgage obligation to 50%. But what if that second mortgage came with a zero, or negative, interest rate, and you didn’t have to pay off the principal until it was due thirty years from now? Your balance sheet is affected, sure, but not your income statement. This thesis is a cornerstone of Modern Monetary Theory,
Some countries are starting to take advantage of this ultra-low interest rate environment. Ireland and Belgium each sold €100 million of 100-year bonds at ultralow rates in privately placed deals in 2016. Argentina sold $2.75 billion of that maturity in 2017, while Austria sold €3.5 billion of 100-year bonds that year at a yield-to-maturity of 1.2% and followed-on with €1.25 billion more at 1% in June.
Yields aren’t negative in the U.S; at least not yet. But with 30-year government bond yields hovering near 2% for the first time, the Treasury Department is said to consider selling debt with 50- and 100-year maturities. Many proponents of large-scale bond issuance at ultralow rates say policy makers are missing an easy opportunity to raise funds that could help generate jobs and income. And despite the national debt more than doubling since the 2008 financial crisis, the politics of debt issuance have grown fraught in recent years. On one side of the political spectrum are Republicans who appear to not be concerned with trillion dollar-a-year deficits, and on the other side are progressive Democrats espousing social policies such as the Green New Deal and Medicaid-for-all that would run into the trillions. That’s not really a problem when money is practically free, and you don’t have to pay it off until a fifty or hundred years from now. As rates trend lower, there is an argument to be made that those worried about the accumulation of government debt should realize that locking in low interest rates for very long terms is ultimately very prudent.
Another argument for adding more on debt at near zero rates is this; in 2018, the Congressional Budget Office forecasted that for fiscal year 2020 the interest to be paid on the U.S. national debt would equal $489 billion dollars, consuming 10% of the federal budget. But that forecast assumed the yield on the 10-year Treasury would approximate 3.7%.[9] It presently stands at 1.5%. There’s room to borrow more.
“There’s free money on the table for the U.S.,” said Adam Posen, president of the Peterson Institute for International Economics. “There’s no reason for the U.S. to hesitate.”[10]
Conclusion
Those that think that interest rates in the U.S. could go negative remain in the minority. However, a slowdown in the global economy, along with signals the 10-year U.S. recovery may stall or even fall into a recession, are indicators that U.S. interest rates may have further to fall. This would give the central bank less room to reduce rates if the U.S. entered a recession. That, in turn, could give it more reason to consider measures such as long-term bond purchases, or even negative rates, as alternative forms of stimulus. Still, a continued decline in yields could have major consequences for U.S. investors and society more broadly, leading to a rethink of modern capitalism and political society once people realize and understand the consequences.
“When the world economy goes into hibernation, U.S. Treasuries—the ultimate safe haven apart from gold—are unlikely to be an exception,” says Joachim Fels, global economic advisor at Pimco. “And if the trade war keeps escalating, we may get there faster than you think.”[11]
[1] “Negative Interest Rates: Definition and History,” Study.com.
[2] “Negative Interest Rate Policy Definition,” Investopedia.com, May 7, 2019.
[3] “The Case for Implementing Effective Negative Interest Rate Policy,” SSRN.com, August 2, 2019.
[4] “Germany for First Time Sells 30-Year Bonds Offering Negative Yields,” WSJ, August 22, 2019.
[5] “Depositors Are Next as Nordic Banks Buckle Under Negative Rates,” Bloomberg, August 12, 2019.
[6] “Depositors Are Next as Nordic Banks Buckle Under Negative Rates,” Bloomberg, August 12, 2019.
[7] “Japan’s Negative Interest Rates Explained,” The New York Times, September 16,2016.
[8] “Investing in the Strange Negative Yield World,” CNBC.com, August 20, 2019.
[9] “Interest on the National Debt and How it Affects You,” thebalance.com, August 12, 2016.
[10] “Yields Plumb New Lows, but ‘Century Bonds’ Remain Scarce,” The Wall Street Journal, August 27, 2019.
[11] “Sub Zero: The Topsy-Turvy World of Negative Interest Rates,” The Irish Times, August 13, 2019.
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