Why Interest Rates Will Asymptotically Approach Zero Forever (Part 2 - Specifics)
by Srikant Krishna (email@example.com )
In the previous post we had set the stage after the largest credit (read: debt) expansion bubble in the history of the world. Affluence truly seemed both eternal and contagious, changing lives and the standard of living around the globe. Central banks aberrantly contemplated that they firmly had control of interest rates, and through it the price of time, and in transitive sequence, a general manipulative mechanism on economic growth.
But in reality, they were absurdly incorrect. The global financial crisis has at its roots many causes, but the capability can be assigned to two very basic human characteristics: incompetence and greed. Whereas politicians all over the world were making promises that could simply not be funded, primary dealers of bonds were more than happy to comply by funding deficits across many developed nations. And central bankers, ostensibly a component of the incestuous revolving door apparatus that conjoins politics, academia, policy institutions, central banking and investment banking, suffered from exceptionally pathological delusional incompetence.
As individuals, corporations, and finally governments attained the economic analog of the Malthusian carrying capacity in terms of debt and the ability to service it, the global credit and financing systems began to collapse, and with it, a massive indiscriminate delevering across the board produced what is known as the Global Financial Crisis. After all, a debt based monetary system requires both the principal and interest to be repaid - or in another words, a perpetually exponential growth in the issuance of credit. If, by whatever reason, endogenous (war, depression) or exogenous (natural disaster), the credit issuance mechanism were to be retarded, the funds required to pay the interest component of debt service would not be available (and perhaps neither the principal), and the entire system deflates back to reality through an endless series of defaults.
During this period, U.S. Treasurys attained extremely low yields, and remained that way for the subsequent years. Investors felt the safest instruments to park their assets were U.S. Treasurys, backed by the full faith and credit of thousands of nuclear warheads, hundreds of foreign bases, and a very aggressive and cogent policy, driving the yields down on these instruments. Additionally, coordinated central bank action across the globe resulted in massive backstopping of otherwise insolvent financial institutions through a combination of mechanisms including asset purchases, repos, and lowering of both the EFF and discount window rates in the United States and their equivalents abroad.
Europe, however, was beginning to fall apart at the periphery (even though the core itself has been rotting for quite some time now). Some modicum of recovery seemed to finally occur in the summer of 2009, but this was short lived until precisely the Greek chaos that ensued in the spring and summer of 2010. The situation continued into 2011, with the collateral damage including the ablation of MF Global and "rumors" of pending calamity at Jeffries. It was the ascendancy of Mario Draghi to the throne as the head of the ECB, and an extraordinarily determined European bureaucracy that finally compressed PIGS yield spreads from an inevitable fiscal collapse. But I hear that a substantial portion of the populace is burning freshly cut forest wood for warmth this winter...
The purpose of this pair of articles is explain why interest rates will remain low forever, and asymptotically reach zero (and a concomitant negative real yield). There are three required factors that would elicit, sustain, and promote this phenomenon indefinitely in the absence of popular and social abrogation: the mathematics of bond yields, the unsustainability of fiscal provisions, and the intervention of central banks. Let us now explore in detail each of these requirements and contributing factors to the zero interest rate environment that has become the new normal.
From a basic mathematical perspective, with the intuition and practice that can be attained in grade or high school, we can understand that the yield on a bond instrument can be represented as k/x, where k represents the original payments in the interest service, and x is the price of the bond. Visually, as the price of the bond increases, a plot of the yield versus the price becomes extraordinary flat. Mathematically, as the price of the bond (x) increases to very high levels, the derivative, or rate of change, of this function (-k/x^2), approaches zero. The largest rates of change of yield with respect to price is when the price of the bond is very low. This is one of the reasons why in the summer of 2011, yields in peripheral European countries were exploding. However, once the price of the bond is forced to be sufficiently high, either by endogenous market participants (funds), or exogenous factors (central bank intervention), it is exceptionally difficult to influence the yield based on the simple aforementioned relationship. Therefore, it only required that the ECB, BoJ and the FED push bond prices to a certain level whence it becomes absurdly facile to maintain low rates.
Secondly, if bond yields were to increase, many so-called "developed" economies would become insolvent overnight. The cost to service the debt would far exceed the income generated by taxation revenue for these sovereigns. Personally, I believe that the central banking system frankly does not commend this sort of fiscal subterfuge and immorality, but is forced to participate in the suppression of rates for purely political purposes. Let us be honest, and state that central banks today are far less "independent" than they insist, and are increasingly branches of fiscally insolvent (read: inept) governments. After all, when presented with the scenario of a standing army of soldiers and domestic police demanding promised benefits, versus a small group of highly educated gentry in suits, my expectations of the superiority of enforced subjugation certainly lie with the former group. Yields cannot increase without corresponding widespread social chaos, and therefore will be suppressed by an increasingly politicized banking system.
The final reason that bond rates, will in perpetuity, remain low for "certain developed nations" has to do with the practical basis underpinning fiat currency. This topic has been well discussed both in the real world and the ethereal internet, so I will neither profess any particular bias nor explanation. But in the context of examination of factual evidence, given the previous two reasons, all that is required for central bankers (or primary dealers and equivalents) to retain or suppress interest rates is to simply to act as marginal buyers. It is purely this simple. Given the mathematical relationship between yield and prices, and the political incentive, nay charter, that is extended to certain financial institutions, all that is required is a slight excess of demand (buyers) over supply (sellers) to forever maintain the low interest rate requirements. But unlike hedge funds, retail investors, sovereign wealth funds, and even investment banks, the singular capacity afforded to those "privileged" nations with a central banking system will ensure that bids can be conjured from the void, and digital funds are transmitted within femtoseconds, immediately leaping into the commodities and "risky" asset markets. Good luck with your USD $6 chai latte.
As the real economies across the globe continue to decline, and the indulgent promises afforded during the extravagent years come to fruition, it is the confluence of these three powerful characteristics that will ensure that yields remain low. Until of course, social or natural phenomena disrupt the engrained charter than has not been sapiently decided, but rather forced, upon swaths of the world.
Copyright © 2013, Srikant Krishna
Srikant Krishna is a financial technologist and quantitative trader. He has a background in biophysics, software development, and the capital markets.
You can visit his blog as well.