The Low Rates Paradox

 |  Includes: DTUL, DTUS
by: IndexUniverse Europe

By Paul Amery

Rock-bottom interest rates make sense as a way to get us out of recession, right?

Yesterday’s feature, which describes how ETF providers and investors are reacting to the record low levels of bond yields, got me thinking about whether governments’ low interest rate policies are actually working.

Here, for the record, are some of the wafer-thin yields to maturity on offer from a random selection of short-maturity European fixed income ETFs.


AUM (€m)

YTM (%)

TER (%)

iShares Barclays Capital $ Treasury Bond 1-3




iShares eb.rexx Government Germany




iShares eb.rexx Money Market (DE)




db x-trackers EONIA TR Index ETF




db x-trackers € Sov. Eurozone 1-3 TR ETF




Click to enlarge

The fact that your return on cash and on short maturity bonds is barely positive, and doesn’t leave you with much of a return after expenses, is hardly news. Incidentally, returns don’t always cover fees – as commenter Rick Ferri pointed out last week at the foot of our news story describing iPath’s eight new US-listed Treasury bond ETNs, “the 2-year T-note has a yield to maturity of 0.52% and the iPath US Treasury 2-year Bull ETN (NASDAQ:DTUL) has an annual fee of 0.75%. So, exactly how are investors supposed to make money on this?”

On a real return basis, savers faced with near-zero interest rates are already operating at a steady loss of course, particularly in the UK, where inflation has topped the government’s 2% target for 42 of the last 51 months. Effectively, those with spare cash (probably less than half the population) are being taxed to encourage the rest of the economy to borrow...even though excessive indebtedness was what got us into the crisis in the first place.

That’s an argument that politicians clearly don’t want to hear in the UK, given their emphasis on getting banks to lend more (which means that the same banks’ clients have to want to borrow the money on offer, something they so far seem rather unwilling to do).

But, more importantly, do zero interest rates really work to stimulate the economy?

As consultant Mercer has just pointed out, falling corporate bond yields have worked to counteract the improvement in UK pension fund deficits that has come about since equity markets bottomed out in March last year (UK pension fund liabilities – the costs of providing future pensions – are calculated by discounting future payments by a notional corporate bond yield, so the lower the bond yield, the higher the present value of liabilities and the bigger the fund deficit).

In the US, falling Treasury and corporate bond yields, plus a negative 10-year return from equities, make public sector pension funds’ debate (here’s an example) over whether to shift their discount rate assumption down from 8% to 7% rather surreal, given how far away they are from current market rates of return. But if US public sector bodies halved their discount rate assumption, they’d be more insolvent than many already are.

And, on a slightly different tack, an article published yesterday by Conservative MP Jesse Norman hints at the government’s intention to try to renegotiate the 25-30 year Private Finance Initiative (PFI) deals awarded by the previous administration, many of which provide 8-10% taxpayer-guaranteed returns to the contractors concerned.

Britain’s PFI rip-offs might indeed, as one commentator put it, “make the Camorra splutter into their grappa” by the sheer scale of their looting of the taxpayer. Thanks, Gordon. But while lowering interest rates on the contracts might seem only fair, it could push some of the debt-laden PFI contractors themselves over the edge, with knock-on effects on jobs and overall economic demand.

These examples hint at the low rates paradox. Cut the rate of interest more, and you just force the economic survivors – those saving – to increase the amount they are putting aside to make ends meet, while spending even less. Good businesses have no real incentive to borrow, as economic demand is shrinking. Worse, the bad businesses that should be going bust are kept alive to take away demand from the good ones.

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