For all of financial history, there has been a basic premise. The premise was that if I loaned you money, you would pay me back more than I lent you. Typically, the money paid back that is above the repayment of the principle is classified as “interest”. Even in Muslim countries that do not believe in interest, there is a fee charged for the privilege of borrowing money.
For hundreds of years, economists did not know that numbers below zero existed in the world of money lending. But within the last two years, economists all over the world made a startling and exciting (to them) discovery. There are, in fact, numbers below zero. These are negative numbers. Once they discovered that there were negative numbers, they wasted little time in deploying negative interest rates, which completely blows up the premise of getting more back in return for lending. Instead, for the privilege of borrowing money, the lender pays the borrower more money.
Let’s think about this in a real world example, using simple numbers. You decide you want to buy a new pick-up truck and the price is $50,000. You do not have that money in your wallet while you are at the dealership, so you decide to finance. Having borrowed money before, you know that you always pay back more than the original borrowed amount, so you expect that the truck will cost you roughly $54,000 based on a 3% rate for 60 months. But wait, the dealership has great news, rates of 3% are so last year. Now the rate is -1%. “What does this mean?” you think. It means that the $50,000 pick-up truck will now only cost you $48,700 after you make all your payments.
Another example would be a bank deposit. You take the $10,000 you won from the lottery to your local bank. The interest rate for deposits is -0.1%. You put your money in, and in a year, you check your deposit to see it has grown to $9,990. This must be a mistake, right? These small, imprecise examples are actually how negative interest rates work. Unfortunately, for all you car shoppers, negative rates are not in the United States, and are not at car dealerships.
Negative interest rates are currently being deployed by Central Banks in Europe and Japan. Roughly, $12 trillion dollars in debt is in negative interest rates. This means the people that are buying bonds are paying for the privilege of lending money, rather than getting paid. The main reason that Central Banks have resorted to this historic tactic is to get money moving faster and thereby increase inflation. The faster money moves, or the velocity of money, is a contributor to inflation. Inflation is a goal of every Central Bank, for a variety of reasons.
I mentioned previously that we do not have negative interest rates in the United States. So, why do negative interest rates matter here? One reason they matter is the unprecedented nature of the experiment on such a large scale in countries that are highly interconnected with ours. If the experiment goes wrong, it will have major implications for the US. Rather than running through hypothetical scenarios, of which there are many, I will focus on what is happening due to negative interest rates right now.
For those who do not watch the stock and bond markets consistently, you may not understand the disconnect between stock prices and the companies underlying earnings. Typically, a stock can be reasonably valued by the cash flow a company produces. This is due to the stock being an equity claim to a proportional share of the cash flow. However, the S&P 500 has recorded four quarters of declining earnings, and will more than likely show a fifth quarter of declines at the conclusion of the Q2 2016 reporting period. Meanwhile, stock prices have been rising. This is an effect of negative interest rates. Money from around the world is looking for a place with positive returns, and US securities with even the most meager yields (dividends or interest) are better than the sure loss that negative interest rates provide. In the bond market, interest rates and yields on fixed income securities continue to tick down. Again, if faced with the decision to lose money, or make 1-1.5% most would chose to make money. Hence, money is flowing from around the world into the US, inflating the price of Fixed Income securities, and reducing the yield.
The inflation the Central Banks desire is happening. However, rather than happening in the real economies of their home countries, the inflation is occurring in the financial assets of the US. In fact, signs are emerging that the negative rates are encouraging more savings and slowing the velocity of money in their countries, the opposite of the desired effect.
While most negative rates have not been passed on to consumers, the ultralow rates of return that savers are receiving means that the power of compound interest is reduced, forcing more savings to achieve goals. The fear is that if negative rates were passed on to consumers, they would move their money out of banks and into cash, paralyzing the entire financial system. Hence, some folks have been floating the idea of banning 500 Euro notes and $100 bills, to make holding savings in cash more difficult. Of course, the proponents of a large note ban portray the idea as though it would reduce crime and terrorism.
The question for us in the US is “What will happen if all the money flowing in to the country suddenly starts flowing out of the country?” The short answer is most financial securities will decline in value. This could be a scary scenario, but these types of movements do not happen overnight. There would be signs of strengthening in the Eurozone and Japan. The Central Banks would start raising rates out of negative territory, and the dollar would more than likely depreciate relative to other currencies.
In the short term, it is good to be a spender and take advantage of low rates (30 year home mortgage rates are in the lower 3-4% range as of this writing), or own equities which should continue to benefit from low rates and stimulus in other parts of the world. It will continue to be less advantageous to be a saver, as savings accounts and Fixed Income will continue to deliver low yields.
Long term we do not know how this will play out, as the negative interest rate experiment has never been tried before. There is a building belief that this experiment will be a long term negative as savings and investing will decrease, and research and development will decrease. But who knows, there are a lot of different arguments for and against negative interest rates, and dozens of economists for each one.
Stay tuned and work with a retirement plan manager or adviser who can navigate the complexities of the negative interest rate experience. He/she can help create a top-performing plan or investment portfolio for you while keeping in mind what is appropriate for your risk tolerance. To learn more, call 800-234-9584
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