Negative Interest Rates Imply the Credit Crisis Began Much Earlier

by: Daryl Montgomery

At one point on November 19th, the yield on a new 3-month U.S. T-bill fell to 0.005%. A rational person would think you couldn't go lower than that, but a rational person would be wrong. The yield on 3-month bills maturing in January 2010 briefly turned negative. This was not the first time in recent history. It happened on December 9th, 2008 as well at the bottom of the Credit Crisis, or at least what was perceived to be the bottom so far. A 3-month T-bill auction on that date had a high bid equivalent of 0.000%. Apparently not everyone got in at that great rate.

Interest rates below zero are theoretically impossible. After all why not just keep the cash instead of settling for less money after a period of time? They do happen in the real world, however, and are an indication of extreme risk aversion on the part of banks. They are a marker of severe financial crisis. Contrary to popular belief they don’t indicate deflation.

Long-term rates have to also be close to zero to draw this implication. Before the current Credit Crisis, T-bill yields were only negative in the U.S. in 1940, after years of financial stress from the Great Depression. The auction low for T-bills was 0.01% in January of that year. Rates apparently went negative because of punitive property taxes imposed by a number of U.S. states. T-bills were not taxable and investors kept more of their money by taking a slight loss on T-bills than if they had paid the tax. No such special circumstances exist today to justify negative rates. The explanation for current negative rates is that banks are loading up on short-term government instruments to improve the appearance of their year-end balance sheets.

Negative interest rates also took place in Japan during their current 19-year (and counting) financial debacle. Short-term interbank lending had a negative return one weekend in January 2003. As was the case in the U.S. during 1940, years of severe financial stress preceded this event. In Japan's case there were a series of rolling recessions - the modern version of depression thanks to government's now common practice of continual economic stimulus programs. There have been other cases of negative interest rates, however these seem to have been utilized (usually officially by the government) as a type of currency control. Switzerland imposed negative interest rates during 1970s after years of appreciation of the franc, for instance, but only for foreign depositors.

The usual appearance of negative interest rates after a long period of financial stress raises the question of when economic problems actually began in the United States. It is reasonable to assume that they started long before the awareness of the Credit Crisis in 2007. Interest rate anomalies may have in fact already existed in 2003.

While it is not generally known, between August and November some U.S. government repurchase agreements had negative rates. There is more than enough evidence to indicate that a long-term recessionary period actually began in the U.S. in 2000. Manipulated inflation rates and GDP calculations hid the details from the public. The U.S. government, businesses, and consumers lived off ever-increasing borrowing and this made up for declining income. The Credit Crisis was merely the unraveling of this scheme, not when the financial problems started. The return of negative rate indicates a deeply entrenched problem within the U.S. financial system, and it doesn't look like it has been fixed yet.

Disclosure: No position in T-bills.