The Truth About Negative Yields

After the financial crisis of 2008/2009, the term ZIRP became commonly used — zero interest rate policy. The major central banks throughout the world adopted policies of loose money and low interest rates, which typically go hand in hand.

The Federal Reserve never officially adopted a target rate of zero percent. Its federal funds rate (the overnight borrowing rate for banks) was between zero and 0.25%. It’s close enough to zero.

The short-term rates on Treasuries also followed suit and were at or close to zero. This was a similar occurrence in other major countries.

Now we have gone from ZIRP to NIRP. If it weren’t already insane enough, we now have to deal with a negative interest rate policy.

This policy makes little sense. It is an attempt to repudiate the time value of money. Most people would rather have a dollar today than a dollar one year from now. And if you loan a dollar today to be repaid one year from now, you typically get paid some kind of interest.

The interest rate represents a price on the money in accordance with the timeframe of the loan. The interest is compensation for giving up something today for someone else to use. The interest rate can also account for the risk of a default. In the case of most government debt, there is obviously a very low chance of any kind of a default, at least as perceived by the market.

Many countries in Western Europe have negative yields. Greece is an exception. The interest rate on a 10-year bond is close to 8%. There is still fear of a default. This does not appear to be the case in other countries in that region.

With the news of the Brexit, yields fell further. In many places, the yields appeared to go higher, until you realized there was a negative sign in front of it. Since then, stocks have recovered, but yields have mostly stayed down.

The Numbers Keep Growing

When you consider that major economic powerhouses such as Japan, Germany, and Switzerland all have negative yields, there are going to be some major distortions in the market.

And it isn’t just short-term debt that is paying out (or is that paying in?) negative rates. The 10-year yields in all three of these countries are negative. In Switzerland, even the 30-year yield has turned negative.

On a global scale, the total negative-yielding debt is now approaching $13 trillion, if it hasn’t been surpassed already. This number is practically incomprehensible. It has gone up about $2 trillion just in the last few weeks with the Brexit vote.

The entire GDP of the United States is just under $17 trillion. The total global debt with negative rates will likely surpass the entire annual output of the United States, unless something turns around quickly.

You may be asking yourself who would be foolish enough to buy debt that collects interest from the lender, instead of the other way around.

It is not your average Joe buying this debt. It isn’t some middle-class guy contributing to his 401(k) (or similar plans in other countries).

Maybe a tiny fraction of this negative-yielding debt is owned directly by the middle class. But most of it is owned by the big players. Some of it is owned by large pension funds that may not have many other choices. Some of it is owned by large financial institutions.

Even wealthy individual investors may find few options if they seek safety. They would rather lose a small percentage instead of going into riskier assets where they might lose more.

Of course, the number one owner of this negative debt is central banks. This is how they create money out of thin air — they buy government debt and then type in digits on a computer screen to the broker who sold the debt.

In the case of Japan, the central bank there is buying a large portion of the debt. It has ruined a culture of saving in Japan. The Japanese people have to find other ways to save. That is why sales of gold are up in Japan. It is also apparently becoming more common to hoard cash outside of the banking system.

But these policies have their consequences, one of which is to discourage saving. And when people do save, they are essentially forced to look for riskier investments.

In Japan, the economic system named after its prime minister is Abenomics. It is basically Keynesian economics on steroids. With all of the massive monetary inflation and spending and debt, the economy is still a mess. It can’t even get a short-term boost from the artificial stimulus. Yet they keep going back for more.

The Exception

The U.S. economy no doubt has a lot of problems. This is why so many people are fed up with the status quo, which has shown in the political arena.

The Fed had its own policy of loose money with the financial crisis. The government debt keeps going higher, despite a supposed recovery. Meanwhile, real incomes are stagnant at best.

But the Fed is playing its own game as compared to the other major central banks, most notably the Bank of Japan and the European Central Bank. While the rest of the world is awash in loose money and negative interest rates, the Fed has backed off.

To be sure, the interest rates are really low in the U.S., especially by historical standards. The Fed has only raised its target rate once since the financial crisis, and that was a quarter-point hike late last year. Market interest rates have gone down.

And the Fed did have a really loose monetary policy from 2008 to 2014. It basically quintupled the adjusted monetary base. But while its balance sheet grew astronomically, price inflation has stayed relatively low, with fear and a lack of bank lending holding things down.

Since late 2014 — the end of QE4 — the Fed has been in tight money mode. The monetary base has been essentially flat. Yes, the Fed is keeping its balance sheet where it is. That is, it is buying more bonds with principal payments. And it is rolling over maturing debt. But it is not actively increasing the money supply like what Japan is doing now.

So lower interest rates in the U.S. are not a reflection of central bank buying. This means private investors are buying up U.S. debt at low yields. The 10-year yield on U.S. Treasuries is now below 1.5%.

Whether it is foreigners or Americans, there is no question that U.S. Treasuries are seen as something of a safe haven right now. In terms of outright default, the investors are probably correct.

Blowing Bubbles

When a central bank creates money out of thin air and institutes a policy of artificially low interest rates, it causes artificial booms. Eventually you get the busts as well.

In the case of Japan, the economy is so bad that the bubbles aren’t even seen as a form of prosperity.

There is likely still a lot of malinvestment in the U.S. from the Fed’s previous monetary policy. At least in the case of the U.S., the Fed isn’t continuing to make it worse by creating even more money.

The shakeout in Japan is going to be bad. It is not a matter of if, but a matter of when. The U.S. economy has its own issues, but hopefully we will not go down the same crazy path as Japan and Western Europe. You can also throw China in there, too.

Still, the demand for U.S. Treasuries doesn’t just mean a bond bubble. It also drives investors into taking chances that they otherwise wouldn’t. Who wants to hand over their money for 10 years in order to get less than 1.5% per year for a return? It is not exactly a way to get rich, even for high savers.

This may be part of the reason we are seeing a rise in gold and stocks as well. People are searching for yield. As long as we are not in a recession, it will be tough for investors to stay away from stocks.

I continue to stay cautious on stocks, but you shouldn’t fight the trend, either. It is important to diversify, which can include some solid dividend-paying stocks.

You can even include a small percentage in U.S. Treasuries. It will serve your portfolio well if there is a recession. If you are American, at least you don’t have to pay the government to buy its debt.

Until next time,

Geoffrey Pike for Wealth Daily