Negative Interest Rates, Part One

December 23, 2019

Imagine for a minute that you are saving to buy a car. Checking your bank statement, you see that the current balance is less than what you’ve deposited. This is the realm of negative interest rates ­— where cash balances can shrink rather than grow.

In response to struggling economies, central banking authorities in Europe and Japan turned their worlds upside down in just this way some five years ago. Instead of paying interest on funds deposited overnight by commercial banks, they started charging interest. Pressing further to stimulate growth, those same banking authorities aggressively purchased longer-dated bonds to the point where the return for holding them to maturity descended into negative territory as well. At last count, about one-quarter of the world’s investment-grade bonds were trading with a negative yield!

Many older, more developed economies continue to face significant challenges brought on by aging populations that are neither working nor spending much and overcapacity that can’t be addressed due to labor-friendly regulations. Discontent fueled by rising unemployment brought bold monetary stimulus. The central banks’ goal was to prod the banks to lend, so that businesses would build new plants, buy new equipment and hire more workers. Thus far, potential borrowers haven’t shown much demand for additional funding – even when no interest is being charged.

The US economy looks to be in comparatively better shape. Year-to-date, the US economy has grown at an average pace of 2.4% versus 1.5% in Euroland and 2.1% in Japan. Admittedly, our population grew by just 0.6% in 2018, the slowest rate registered in the past eighty years, but it is not expected to slow much further. The US Census Bureau predicts 20% population growth by 2050, while Japan’s population is projected to shrink by 20% in that time (United Nations — World Population Prospects 2019). Immigration is an important contributor to the US outlook, as is a more optimistic populace - one more inclined to spend and procreate. New business formation is far higher than elsewhere. A tight labor market reinforces America’s confidence. It’s no coincidence that US interest rates are the highest among all developed market nations.

All the while, the ubiquitous digital marketplace has transformed the world economy into a giant price war and the US is not immune to its deflationary effect. The thirty-year trends of falling inflation and falling interest rates do not have to stop at zero. We can’t identify any barriers that would prevent US rates from sliding into negative territory.

Our base case, however, is a bit cheerier. The United States, for several reasons, has more room to maneuver than most expect. Having the world’s reserve currency means there is a nearly unending demand for our debt, at least for the time being. There will no doubt be bumps in the road, but more likely than not, the US looks unlikely to go the way of Europe, or worse, Japan, anytime soon. Even if growth slows and interest rates fall further, US policymakers could and probably would respond to the prospect of negative rates (and likely an accompanying recession). Fiscal stimulus — which would involve (more) massive deficit spending — requires political cooperation that may not seem possible today but would likely coalesce in the event of a crisis. We can imagine a package of infrastructure (roads, bridges, high voltage electricity transmission lines, etc.) spending in tandem with the issuance of more bonds. Adding a supply of 50-year or 100-year Treasury bonds to fixed income markets to take advantage of historically low rates might do the trick, depending on how the money would be spent.

Whatever 2020 has in store, we look forward to navigating it with you. Our next piece will focus on making investment decisions in a low interest rate world. From all of us at Rock Point, we hope you have a healthy and happy holiday season!