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Negative rates are a Pandora’s Box

About $15 trillion worth of bonds worldwide now carry negative yields

Gordon Pape says negative rates are a Pandora's Box.By Gordon Pape, Editor and Publisher

The U.S. Federal Reserve Board reduced its key interest rate by a quarter point earlier this month. It was the second meeting in a row that chairman Jay Powell and his fellow governors had eased the target for the federal funds rate, which now stands at 1.75-2.00 per cent.

Did that satisfy President Donald Trump, who has been pressuring the Fed to drop rates? Absolutely not! Barely a half-hour after the announcement, Mr. Trump unleashed another Twitter storm, bashing Mr. Powell (who he appointed) and his colleagues.

Jay Powell and the Federal Reserve Fail Again,” he wrote. “No ‘guts,’ no sense, no vision! A terrible communicator.”

The President continues to lay the blame for the slowdown in U.S. economic growth on what he sees as weak Fed policies. Lower interest rates – in fact, much lower – would fix everything, he seems to think.

Mr. Powell disagrees. During a press conference following the announcement, he cited “volatile” trade policies as causing uncertainty in world markets. “We do see those risks as actually more heightened now,” he said.

The last thing Mr. Trump wants to hear in the run-up to the 2020 election is that his trade policies are contributing to slowing growth. The Fed, which is supposed to be politically neutral, has emerged as a convenient scapegoat.

It appears that what the President really wants is the Fed lower its target rate to zero or even less. He sees that as a way to refinance the $22 trillion U.S. national debt at a very low (or negative) cost, stimulate the economy, and free up money for more spending, such as his border wall.

If that results in negative interest rates in the U.S., it would suit Mr. Trump just fine.

The USA should always be paying the lowest interest rate,” he tweeted at one point. “It is only the naivete of Jay Powell and the Federal Reserve that doesn’t allow us to do what other countries are already doing. A once in a lifetime opportunity that we are missing because of ‘Boneheads’.”

That tweet came after the European Central Bank reduced its deposit rate by 10 basis points to -0.5 per cent earlier in the month and embarked on a new program of quantitative easing to attempt to kick-start a lethargic European economy.

So, do negative rates work?

Thus far, there’s not much evidence that they have done much to stimulate sagging economies. Europe has had them since 2014 and is now bordering on recession. In Japan, where the central bank introduced them in 2016, growth remains elusive. Supporters of the idea argue that those economies would have been worse off without going negative but so far there has been no conclusive proof either way.

Investopedia describes negative rates as being “an unconventional monetary policy tool employed by a central bank whereby nominal target interest rates are set with a negative value, below the theoretical lower bound of zero percent. A (negative interest rate policy) is a relatively new development (since the 1990s) in monetary policy used to mitigate a financial crisis”.

The U.S. is certainly not in a financial crisis at this point. Neither are Europe and Japan for that matter, although their economies are sluggish.

But what should be used as an extreme measure for emergencies is gaining traction. About $15 trillion worth of bonds worldwide now carry negative yields (the actual number varies daily as bond prices fluctuate).

Think about what that means. If you are the owner of one of these bonds, you have to pay the issuer to hold your money and guarantee your principal. You not only get no return, but it costs you. So far, negative rates have affected mainly institutional investors, but they are now creeping into the retail market.

For example, some Danish banks are offering negative rate mortgages. That means if you want to buy a house, the bank will pay you for using their money! A report on Bloomberg by Frances Schwartzkopff says Dankse Bank AS estimates that Danish homeowners may switch as much as US$70 billion in fixed rate mortgages this year to take advantage of the attractive rates.

What would it mean for North Americans if negative rates come here?

We can only speculate since this whole phenomenon is very new. But the Bank of America is on record as saying it’s a “possibility”.

With that in mind, here are some points to consider.

A housing bubble.

If mortgage rates were zero or less, everyone would want to buy a home. Stress tests would become much less onerous, expanding the number of potential buyers. If you think prices in Vancouver and Toronto are out of sight, a negative rate environment could create a bubble of unimagined proportions.

Savers would suffer.

Would you put your money in a bank account or GIC if you had to pay the bank to keep it for you? Hiding it under the mattress is cheaper.

Debt would increase.

Canadian household debt is already at record levels, alarming economists and the Bank of Canada. If it costs nothing to borrow, or if the bank pays you, where do you think debt levels will go in the future?

Stocks would rise.

When fixed income investments are paying negative returns, the stock market looks a lot more enticing. The result would be equity inflation, with all the risks that entails.

Pension plans would suffer.

Defined benefit pension plans are structured on the basis of actuarial calculations that assume rates of return from the invested assets. If the fixed income portion of the portfolio turns negative, the ability of the plan to pay its obligations to members would be jeopardized.

Gold would soar.

One of the main objections to investing in gold is that it pays no return. In a negative interest rate environment, that concern disappears. Why collect zero interest (or worse) from the banks when gold offers safety and potential profit?

Banks would suffer.

A significant percentage of bank profits comes from the difference between the interest they collect on loans and the amount they pay on deposits – the net interest margin, or NIM. Lower interest rates reduce NIM, and hence profitability. With negative rates, the NIM would be squeezed to almost zero. To compensate, banks would have to turn to other sources of revenue, including raising fees on all the services they provide.

All this is just the tip of the iceberg.

We’ve never experienced negative interest rates here so we have no way of knowing how people will react if the trend jumps the Atlantic. President Trump should be careful what he wishes for. This looks like a classic Pandora’s Box.
This article was originally published in The Toronto Star.

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