07 July 2016
Accentuate the Positive – Eliminate the Negative
How low can interest rates go?
by Frank O’Nomics
It has finally happened, the world has turned upside down, and it seems that one and one does not equal two. Those who have read Keynes’ General Theory will perhaps remember his assertion that “the rate of interest is never negative”. Not exactly an earthshattering statement, but it now turns out that he was wrong. A number of central banks in the developed world have cut the interest that they pay on deposits left with them by banks to negative levels, and core European Government bonds have negative yields a long way out on their yield curves, which in the case of Germany means beyond 10 years. The phenomenon hit the UK last week when, in response to an investor flight-to-quality and expectations of an imminent Bank of England rate cut, yields on some short-dated gilts (UK government bonds) turned negative for the first time. Put simply, under these circumstances, if you lend the government money you have to pay for the privilege of doing so. To understand why anyone would contemplate taking on an investment that was guaranteed to lose money, we need to appreciate the causes of negative interest rates. However, the bigger questions surround the broader implications of very low, or negative, interest rates, and in many respects that picture is really quite bleak. If that is the case it seems very important to examine what can be done to either reverse the process, or to come up with alternatives to further cuts in interest rates.
In looking at why interest rates have fallen so far, one really needs to go back a long way before the financial crisis of 2008, although it is fair to say that the events of recent years have added a new impetus. The fall in interest rates has fundamentally been the result of a glut of savings and a shortage of investment opportunities on a global scale. Some of this can be attributed to the ageing populations of major developed nations (Japan being the prime example), but huge and ever rising debt levels at both a household and governmental level has meant a combination of weak private investment, and falling public investment. Add to this a decline in productivity growth and you are left with something that gets close to stagnation. The more recent driver of falling yields has undoubtedly been central bank policy in response to the aftermath of the financial crisis of 2008. Once bank rates were reduced to near zero, central banks resorted to the closest thing to printing money, with the widespread adoption of quantitative easing. As central banks have bought almost all of the free float of government bonds (commercial banks and pension funds will hold on to some come what may) yields have been driven down to negative levels in Japan, Switzerland and all of the Eurozone nations except the Club Med countries. Now that this has finally happened for some shorter dated gilts you might assert that it is no bad thing. The reduction on borrowing costs for the government is a huge benefit in the process of tackling the budget deficit and potentially presents an opportunity to increase public spending. The argument that you are creating a potential debt replacement problem for future generations is easily countered by the prospect of their having new roads, schools and hospitals in return. Similarly, the reduction in borrowing costs by the fall in yields on corporate bonds (and the ECB is now rapidly hovering up these in the latest extension to QE) means that borrowing costs for investment grade companies has significantly decreased. However, there are sadly many damaging connotations of low or negative interest rates that effect both households and corporate entities.
First of all there is a huge issue for savers. Those who retired expecting to live on a combination of their pensions and the income from their savings have been very disappointed as the interest on savings has plummeted, but the issue runs much deeper for future retirees. As investors have been forced further out along the yield curve, long term interest rates have been driven lower which, together with the steady increase in life expectancy, has significantly reduced annuity rates so that for every £100,000 of a pension pot that a retiree has, the prospective income that this will produce is now around just £5000 as opposed to £7900 just 7 years ago. Pension freedom has meant that the option of income drawdown can be taken as an alternative to an annuity, but this runs the danger of quickly eroding a pension pot. For pension funds themselves the issue is painfully stark. They are being forced to shore up ever increasing deficits (themselves caused by using low long-term yields to calculate their liabilities) by buying more government bonds, thereby exacerbating the problem.
Secondly, low rates and a flat yield curve create a huge problem for banks, who traditionally make their money by borrowing short and lending long, ie making money from an upward sloping yield curve. On top of this banks have to keep a significant stock of cash in government bonds as a provision against potential bad loans, particularly given the more conservative regulatory backdrop brought in since the financial crisis of 2008. If these government bonds are producing negative returns the banks are effectively having to buy some very expensive protection. They will also have a significant problem if yields were to rise suddenly as this would trigger damaging capital losses. Much as many will have little sympathy for the banks, a sound financial system is a significant prerequisite of economic prosperity and we need our banks to be profitable. In the current environment, even though low interest rates may encourage businesses to borrow, the banks are very reluctant to lend.
If low interest rates are still not working to prompt a turnaround in investment spending, and the use of quantitative easing has merely served to lower bond yields (and to further stimulate a house price bubble) rather than push investors into investing in companies, one must ask what other measures are now needed.
For the UK, the post-Brexit outlook initially looks like being one which prompts a further rate reduction, but the fall in sterling could be sufficient to generate a rise in inflation that would merit a rise in rates. The only other way of generating an economic stimulus would appear to be the use fiscal policy, or indeed any other measure that would generate an economic stimulus. To some extent we have already seen moves away from austerity given the Chancellor’s announcement that a balanced Budget by 2020 is now unrealistic, and he is trying to help further by cutting Corporation Tax. Leaving the EU may mean that we are less constrained by Maastricht rules, but this does not mean that we will be adopting significant rises in government spending or cuts in taxes. Many will argue that there is a limit as to how negative yields can become, given that ultimately people will prefer to hold physical cash (presumably in a safe deposit box rather than the mattress), but this week Japanese 10 year bonds reached -0.24% and 2 year German bunds -0.67%, so we clearly have not hit that point yet. For now the outlook for both savers and investors looks decidedly bleak.
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