Are Negative Rates Really That Negative?

So far, they seem to work in practice, just not in theory. Negative yields seem to have helped extend the cycle, but they carry risks if they linger for too long.

I still remember the classroom silence as my math teacher effortlessly extended the number line on the board to the left and started filling in negative numbers. “They’re just like positive numbers,” he explained unhelpfully. “They’re just negative!” (It took a long time to understand just how combining my positive two apples with my friend’s negative two apples could leave the world with no apples at all.)

My brain gets that same dull feeling when I try to tease intention out of market yield charts that drop below the x-axis. Are markets pricing in the end of the world? Or are negative yields simply an unintended—and ultimately temporary—consequence of the unprecedented response to a global financial crisis? And beyond the practical impact, what about all our financial theories that are based on the bedrock notion that money today is worth more than money tomorrow?

It’s rarely good strategy to bet on the end of the world and, happily, the economic data streams point to a global economy that is slowing, but not collapsing. Equity markets continue to set new highs, and unemployment rates still hover near all-time lows. Yet, even after this month’s rally in risk assets, negative yields aren’t going away.

GLOBAL CENTRAL BANK POLICY RATES

Source: Bloomberg. As of November 14, 2019.

BLOOMBERG BARCLAYS GLOBAL AGGREGATE NEGATIVE YIELDING DEBT (U.S. $TRILLIONS)

Source: Bloomberg. As of November 13, 2019.

More likely negative yields are a vast distortion caused by leaving central banks with a narrow set of tools to cope with the global financial crisis. Their effectiveness has been weaker, especially without reinforcement from fiscal policy, but the economic recovery would have ended long ago had central bankers stopped cutting rates at zero. Denmark was the first to go negative in 2012, and since then Sweden, Switzerland, Japan and the euro area have all followed.

In some sense, this most unnatural of financial phenomena is a logical consequence of a world in which secular forces are contributing to lower returns and slower economic growth. Workforces are growing more slowly due to falling fertility rates and aging demographics. Inflation remains low because of globalization, which keeps price inflation in check, and magic new technologies, which drive down production costs.

These secular trends were already gaining momentum when markets collapsed in 2008 and the world’s central banks uncorked vast amounts of liquidity. This aggravated a savings glut which was already building before the crisis, expanding a supply of capital beyond the pipeline of attractive investments. The result has been low equilibrium rates and one of the slowest recoveries on record.

What’s your local central banker to do in such a world? If the offer of free money doesn’t stimulate enough demand from borrowers, then the next step is to raise the cost to lenders of storing that money through charges on excess bank reserves. Marginal projects should look more attractive when assessed against the prospect of deposits that actually shrink with time. 

Do negative rates work in practice? They worked exceptionally well in one micro-experiment involving a regional currency in Bavaria that slowly lost value if it went unspent. Certainly there is plenty of credit flowing through non-bank channels, and initial studies by the European Central Bank and the International Monetary Fund suggest there has been a boost to credit creation, although it’s probably too soon for a final judgment. 

"It’s rarely good strategy to bet on the end of the world and, happily, the economic data streams point to a global economy that is slowing, but not collapsing."

Worries abound, of course, that the impact may wear off as rates move more negative. There is likely also a “reversal rate” or level at which accommodative monetary policy turns contractionary amid evaporating bank profits. Negative rates hurt the asset-liability structures of pensions, insurance companies and endowments, too. At some point, the prospect of lower pension payouts or tighter lending criteria weaken demand further.

Does it lead to excess risk taking? Perhaps, but that's sort of the point. Soaring equity markets and rock-bottom bond yields have clearly helped extend the cycle. Some buyers of negative-yielding bonds are themselves playing the risk that they will always find someone willing to buy their bonds at a higher price—and an even more negative yield. 

Still, if negative yields have so far delivered some benefits in practice, they’ve also done lasting damage to the theoretical underpinnings of asset valuation and its fundamental principles around the time value of money. 

The capital asset pricing model, the Black-Scholes options pricing model and the humble dividend Discount Model all essentially explode when the discount rate turns negative. 

That rate is most often calculated as r-g, the rate of return less the growth in those returns. If the difference between them is a small number, it can justify very high asset valuations, as we have seen. If the difference turns into a negative number, the models don’t work and there isn’t much of a framework to replace them. 

Pity the poor analysts who must rejigger their algorithms to cope. Think of the jittery investors whose valuations and price targets have suddenly slipped their traditional moorings. Imagine a world in which all investment decisions remind you of the first time your math teacher extended the number line to the left.