What Negative Interest Rates Mean To You

by: Jim Mosquera

Summary

What will the Fed do with interest rates?

Do negative interest rates make sense?

Negative interest rates and deflation.

The Fed will meet this week to discuss whether to raise interest rates. While it appears they will not raise during this meeting, there is the anticipation of a rate hike in June. As I noted in an article towards the end of last year, the Fed does not lead, it follows the market. When they hiked rates towards the end of 2015, short-term rates were already headed up. For the month of January, while the stock market swooned, rates initially fell and have been heading up since. I believe it is unlikely the Fed will raise this week but during their next meeting, after short-term interest rates have already been trending up, they will raise. During this article, I want to examine negative interest rates.

In its simplest terms, negative interest rates mean a depositor or creditor receives less than their original principal, by design. According to Elliott Wave International, as attributed to Bloomberg, one third of all Eurozone government debt sported a negative rate as of the end of 2015. In addition, the ECB's overnight money market rate, and 12-month deposit rates in Swiss, Danish, Japanese and Swedish banks are also negative. Deposit rates plunging into negative territory represents a confirmation of the deflationary forces I discuss at length in my book and other published works. Investor and consumer psychology has turned so that the central banking authorities are desperate to stimulate spending. The negative rates are also stimulating a race to the bottom in currency valuation. This currency race has no winners.

But there is even a bigger fallacy at work when considering negative interest rates. When you, as an investor/saver, make a loan to a government entity, corporation, or a bank, whether you consider these factors or not, the following is at play in determining an interest rate:

  1. Inflation component
  2. Risk component
  3. Desired return

Let's look at these factors individually, holding the other two constant. When acting as a creditor, if inflation is in play, at a minimum you would like to preserve the value of your purchasing power. While we can debate the validity of the Bureau of Labor Statistics' (BLS) CPI or the Fed's preferred Personal Consumption Expenditure (PCE) inflation measure, let's use 1.4% as stated in the BLS page covering the period over the last calendar year. That means that a 12-month rate should compensate an investor a minimum of 1.4%. It may be impossible to find such a rate for U.S. government debt or a CD rate for this time horizon (the closest CD rate I found was 1.33%). Again, that 1.4% only considers one of the three factors noted.

Now, let's focus on risk. I think it's fair to conclude that no matter the borrower, there is risk. One could safely argue that U.S. government debt is low risk, but it's not zero. The same could be said for other sovereign debt. In the case of sovereign debt, what is your collateral? At least with corporate bonds, the investor is presumably first in line with respect to asset liquidation. This comment does not apply to Contingent Convertible (CoCo) bonds where a company can suspend interest payment and even convert the bond into equity. What about a bank deposit? In this case, the investor is an unsecured creditor. If you feel assuaged by deposit insurance, consider the low funding rates for the FDIC and maximum amounts covered. Considering risk alone should allow one to conclude that this factor should be an increasingly higher number above zero, where the lower bound is U.S. government debt.

The last factor, desired return, encompasses what savings is all about. Savings is deferred consumption. In a simplification, it's your grandmother telling you that she'll let you have ½ of a piece of apple pie now, or if you wait until after dinner, she'll give you a whole piece. You've deferred consumption of ½ of a piece of pie until some future point, albeit not too far in the future. Think of expected return or interest as a ratio of the valuation of present consumption versus future consumption. I suspect this valuation differs with everyone. I might be willing to wait for the extra portion of pie while you are not. Someone else may want to bargain with grandma and ask for 1.5 pieces of pie after dinner instead of 1 (grandma probably wouldn't like that).

If you thought the four horsemen of the apocalypse were going to appear soon, then it might not matter how much pie you were offered, you'd want to consume it immediately. You could say the desired return in such a scenario is close to infinity. Conversely, if you had an expected return equal to zero, you could care less how much pie you were offered now or after dinner. This means you value future consumption the same as present consumption. Unless you lived in some utopia where all wants are immediately satisfied, like Cockaigne, this sort of indifference makes no sense. So even if the inflation factor and the risk factor were both zero, there would always be a desired return.

Taking all of the factors together (inflation, risk, desired return), it is mathematically impossible to conceive of an environment where an interest rate could be negative or even close to zero, and yet that is exactly what we have in some cases. The basic fundamentals of economics have not been repealed. The current case of negative interest rates is a classic sign of deflation. Another way of expressing this is that deflation is a lack of confidence. Persistently negative interest rates will spur demand for cash (another deflationary sign), though that is antithetical to the very reason policymakers want negative rates. This is why you have people like former Treasury Secretary Larry Summers and others advocating for the elimination of the $100 bill in an effort to thwart crime and terror activities. Be wary of those offering solutions to criminal enterprise that involve control of money.

In time, the madness of ZIRP (Zero Interest Rate Policy) or even NIRP (Negative Interest Rate Policy) will further discredit the Fed. If either of these conditions persist, then we may have a world where money is in digital form only.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.