I TAKE off from when I last discussed negative interest rates (NIRs) in my Sept 28,2019 column: “Getting to Grips with the World of Negative Rates.”
Since then, the world has drastically changed. Covid-19 and the sharp fall in global demand left everything in virtual standstill. The OECD expects the rich world’s GDP to fall 6% in 2020. Even the United States, where growth was the best ever in the second half of 2019 (2H19), will contract by 6%–7% this year, with unemployment lingering in double digits. Are NIRs needed now to stimulate growth? NIRs remain unconventional. The Swedish Riksbank (central bank) first adopted it in 2009.
Since then, NIRs have engulfed government bond markets not only in Sweden and Japan, but also most of eurozone, including Denmark and Switzerland – economies grappling with low inflation and threat of deflation. Sweden has since stuck to its guns. Today, bonds have sub-zero returns out to 15 years’ maturity in Japan, France, Sweden and Denmark; out to 20 years in Denmark; 30 years in Germany and Netherlands; and an astonishing 50 years in Switzerland.
As far as I know, Germany has become the largest economy where its entire yield curve is trading below zero. So, looks like NIRs are here to stay – except in US and China as well as India (latter two being Asia’s growth engines); all are struggling with slowing growth and needing more stimulus.
Its record as a stimulative monetary tool is mixed: mildly NIRs have had only moderate success in promoting growth in Sweden; they have also been useful in stabilising the currencies of Denmark and Switzerland by deterring capital inflows. Still, the monetary policy impact is known to offer diminishing returns; the net impact is at best neutral. They tend to encourage capital outflows.
In all, its very concept has befuddled savers, borrowers and investors. Savers are penalised and borrowers, incentivised; investors receive less than their upfront payment for holding debt to maturity. Homeowners are being paid to borrow! In the final analysis, how low interest rates will eventually settle depends on when they start being counterproductive. The danger: investors and borrowers lose when interest rates rise!
The coronavirus pandemic has called forth a dramatic response from central banks.
Frail corporate balance sheets and over-extended markets go far to explain the immensity of their interventions. It was Walter Bagehot, the Victorian-era editor of The Economist (concerned about the negative side effects of a rock-bottom cost of capital), who once said: “John Bull can stand many things, but he can’t stand 2%.” Needing income, investors will take imprudent risks to get it. And if 2% invites trouble, 0% almost demands it.
We all know interest rates are the critical prices that measure investment risk and set the present value of estimated future cash flows. Simply put: the lower the rates, the higher the prices of stocks, bonds and real estate – and the greater the risk of holding those richly priced assets.
In 2010, the Fed set out to lift market prices through a rate-suppression programme, commonly known as QE or quantitative easing. Former Fed chairman Ben Bernanke wrote: “Easier financial conditions will promote economic growth. Lower interest rates would make housing more affordable and business investment more desirable. Higher stock prices would boost consumer wealth and help increase confidence, which can also spur spending.”
And so, the Fed seeded bull markets in the “public interest”. But interest rates also serve to allocate capital. Distort investment values and lots of money are wasted.
As I see it, like a shark, credit has to keep moving. Loans fall due and must be repaid or rolled over (or defaulted on). When the economy stops (where the world effectively now is), lenders are likely to demand cash that not every borrower can deliver. I well recall, going back in history: to resolve the devastating panic of 1825, the Bank of England rendered “every assistance in our power” to help.
And so, following tradition, the Fed set about buying (or supporting the purchase of) commercial paper, mortgage-backed securities, Treasuries, investment-grade corporate bonds, and selective asset-backed securities. Lately, even junk “fallen angels” bonds. Indeed, through a new direct-lending programme, the Fed has become a kind of commercial bank.
Hence, its massive infusions into the so-called repo market that followed this last September’s unscripted spike in borrowing costs. The super-abundance of Treasury securities reflected US’ trillion-dollar fiscal deficits. Persistently low interest rates facilitated that borrowing, as they did the growth of private equity investing, the rise of profitless start-ups and corporate share repurchases, and the solvency of loss-making companies, all funded in the Fed’s most obliging debt markets.
As far as I know, the Fed isn’t considering cutting interest rates below zero, based on a lingering worry that NIRs hurt savers, boost income inequality and encourages the needless taking-on of debt. NIRs are not good for banks. Hence “not an appropriate or useful policy for the Fed.” It has other options including forward guidance and QE, to spur growth. Still, rates on so called Fed funds futures contracts – FFFC (a key tool for investors seeking to bet on or hedge against interest rates shifts) are under pressure. Senior traders in New York tell me few funds or banks are betting on the Fed following peers in Europe or Japan into NIRs. But some banks I know are nevertheless protecting themselves & their clients against this high-stakes tail risk. In a vicious cycle, the more hedging there are in the market, the stronger those expectations for NIRs become. That’s in the very nature of markets.
After all, markets for FFFC are really not that deep. In practice, I am sure the Fed is struggling to shake off the notion that rates (which already hover close to zero) could turn negative. President Trump is a vocal advocate of negative rates, describing them as “a gift.” Still, chairman Powell reiterated last week that it was “not something the central bank was considering.” Central banks that used them have struggled to contain the backlash against them from banks and savers. Nonetheless, FFFC expiring between March 2021 and March 2022 still implied sub-zero US rates last week. Indeed, the July 2021 contract implied a policy rate of -0.03%. So, markets and banks are nervous with a crisis that is so uncertain about the time frame and what the effective policy will be in the future. Not surprisingly, however, investors and analysts are unwilling to rule out the possibility of negative rates. More banks’ clients are seeing NIRs as “a growing, if still unlikely, possibility.” They are now willing to spend money on insurance premiums betting that those policies will never be necessary.
Earlier on, there was hope for a quick V-shaped (even U-shaped) recovery from the Covid-19 pandemic – i.e. a short but sharp collapse followed (not too long) by a significant bounce back to earlier levels. This is not to be. Expectation now is for a “swoosh” (like the Nike logo) recovery – a sharp drop followed by a painfully slow recovery, with the big (and rich) nations – mainly in US, Europe & Japan, not returning to the 2019 level for some time (maybe 2022).
This is sobering indeed. It reflects the depth of the contraction now being extended to the summer. And, as more evidence comes on, rising joblessness and months of social distancing will depress economic activity well into next year. Frankly, I don’t see a quick recovery, and it’s going to be painful. There are lots of reasons. Airlines don’t expect passenger numbers to return anytime soon. Social distancing will make it harder for people to spend until a vaccine is available. Fresh layoffs are on the line for the fall, prolonging the joblessness surge that has already made more than 36 million Americans unemployed. As I see it, the main reason for the darker outlook is that lock-downs are being eased more slowly than originally expected. Even when they do lift, some large-scale activities – including concerts and sports, won’t be possible again for months. Retails and restaurants that have reopened are constrained; consumers (worried about infection risks) are taking time to return to their old habits. Recent surveys I have seen suggest that: (i) more than 70% of Americans expect to avoid public spaces after lock-downs ease; (ii) more than one-half of them are expected to stay away from shopping malls; and (iii) more than one-half plan to scale back on festive & Christmas shopping. The outlook is so uncertain that a string of large companies has suspended financial guidance for the year. The reality is that there are simply so many factors at play at the same time, on such a global scale. All these are eating into investment. Aircraft makers have slashed production, while global auto production is expected to decline as much as 20% this year. Latest data point to the expectation that only 30%-40% of lost output and employment in the US will be recovered by year-end. The recent survey by the European Central Bank found that the eurozone’s economy is expected to possibly shrink by as much as 15% (-3.8% in 1Q) in 2020, and grow by just 4.3% next year. Don’t expect pre-virus levels of activity before 2022. France, Spain and Italy – three of the bloc’s four biggest economies – all experienced record quarterly contractions in GDP in 1Q20. Japan is already in recession. China, where the coronavirus pandemic peaked earlier than in the West and which lifted many restrictions in March, could be a harbinger for US and Europe. As I see it, there is no such thing yet as a new normal. Frankly, most haven’t the faintest idea what the new normal really is. China appears to be emerging gingerly from its period of hibernation, with consumers remaining cautious. After a 21% decline year-on-year in the first two months of 2020, Chinese retail sales recovered somewhat in March, still down 16%. While 80% of restaurants in China have reopened, most operate at only 50%–70% capacity. Indeed, 15% of restaurants are likely to never reopen. I think China’s back to some degree of normalcy, but they’re really operating in “a very living with Covid” environment; but it’s just not like before.
I sense recovery in the US (and the world) economy is coming-on much more slowly than expected. So, it’s necessary to do more, in my view. So far, the Fed has responded aggressively by slashing rates to near zero, and buying more than US$2 trillion in Treasury and mortgage (and other) securities to stabilise financial markets, began lending to SMEs, and promising to lend trillions more, backed by more than US$200bil in funds from the Treasury, to support businesses and state and local governments. Congress had in March appropriated nearly US$2.9 trillion more to support households, businesses, healthcare providers, and state and local governments, or around 14% of national economic output. Still, additional spending will be needed to prevent long-term damage from a wave of business bankruptcies and extended periods of high unemployment.
As I see it, the Fed still has to do more. More important, Congress will have to do much more. Of late, the House passed the US$3 trillion “Heroes Act” coronavirus-relief package. Despite all the stimulus, US unemployment will hit 17% in June (14.7% in April), rising to as high as 20-25% in the course of 2H20. Still, the toll on the Fed is high: by end 2020, its portfolio of bonds, loans and new programmes will swell to US$9.3 trillion (US$4 trillion last year), and then to US$11.3 trillion by December 2022. That’s more than twice the size reached after the 2007-08 global financial crisis.
What then are we to do?
The situation today appears stable. Senior traders active in the markets tell me that few funds & banks are betting on the Fed following peers in Europe or Japan into NIRs. On May 20, UK government sold negative yielding bonds for the first time. For the Bank of England: It is “under active review.” Still, they can’t ignore their 3rd-sense to protect themselves and their clients against any such risk. That’s why markets already price in some chance of negative rates – in spite of clear guidance to the contrary from the regulators. I guess, NIRs are a last resort. NIRs in Europe are partly a response to politicians’ failure to launch either fiscal stimulus or reforms. Nations can learn from its mistakes. Still, markets are pricing them-in anyway. As I see it, the disconnect provides an opportunity to profit by betting that short-dated gilt yields would rise. Similarly, NIRs won’t fit the situation in Asia (outside Japan). Asians are inherently high savers (much higher than Germany, where sales of safes rocketed). Gross savings in Malaysia and Singapore account for about one third of GDP. To keep savings productively employed within the region requires positive interest rates, even in today’s ultra-low interest environment.
Finally, I argued in my May 16 column that US can borrow and print money, and ignore the consequences for now. But monitors inflation. Of course, throwing monetary and fiscal caution to the wind is imprudent, and won’t end well, with the exact nature of tomorrow’s economic pain or death spiral a known-unknown. In the end, the real cure is getting people back to work. Of course, full recovery will only come with the arrival of a new vaccine. Assuming no second wave of the coronavirus, US and the world economy will recover steadily in the course of the latter second half year.
What’s still worrisome is that the loss of many, many SMEs across the world as a result of the pandemic will destroy the life’s work and family legacy of many businesses. This is particularly true in Malaysia. The economy requires more purposeful stimulus; but needs economic structural reforms even more. Present weak recovery discourages real investment and business expansion. That’s why I believe, more well-designed stimulus measures are needed at this time; better more than less. Any unforeseen excess (wastage) arising at this time is worth it since the extra stimulus helps avoid long-term economic damage and leaves behind a much stronger recovery
Former banker, Harvard-educated economist and British Chartered Scientist, Prof Lin See-Yan of Sunway University is the author of Trying Troubled Times Amid Trauma & Tumult, 2017–2019 (Pearson, 2019). Feedback is most welcome. The views expressed are the writer’s own.
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