The Truth About Negative Interest Rates & What To Expect

Negative Interest Rates

I have been pondering interest rates a lot recently, in light of where I think the economy is headed as well as current Fed policy. I mean, who hasn’t been thinking about it? The world is totally upside down with interest rates. And let’s not forget the paper (here, page 2) that became the keynote speech at the Chicago Fed gathering in late Spring 2019.  It was proposed that had we lowered interest rates by 8-10% in 2009 (down to -3.00% area, yes negative) we would have totally avoided recession, and that this should be the blueprint for the future.  It’s actually an admission that the so-called recovery from the GFC is no recovery at all and that it won’t work this time around either.  No, this time is not different.

In any case, I'd like to share my negative interest rate theory with you, with regard to negative nominal interest rates and bonds. It seems that publicly, no one else talks about negative rates, save for a few like Jeff Gundlach, Peter Schiff, Michael Pento, Steve Keen, Jeff Snider, and a couple of others.  Whereas CNBC and Bloomberg bombard us that negative rates are the new normal, these men all say that negative rates don't make sense because who wants to lend money with a guaranteed loss?  I think there is more to it, and there are some subtleties that are missing from the public discourse, and certainly never discussed even in general in the mainstream financial media.

So here goes…

Investor Demand For Bonds

With regard to bonds, we expect a certain range of yields to balance the risk versus reward. The ten-year treasury, for example, is our usual standard-bearer at around 6%, to offer a "risk-free" annual return. It’s not risk-free.  It’s really the “lowest risk” (I disagree), but that is not for this discussion.  For now, the ten-year at 6% shall remain the standard-bearer.  Raise the risk with other assets, and we expect a higher return.  Single-A corporate bonds might trade over a 7% yield by comparison, BB at 8.5%, and common stock on average might offer 10%-11% when including the dividends. 

If the bond yield is too high, it indicates that the risk is also too high, and the demand by investors for that bond will fall until the yield reaches a certain elevated level and there will not be any demand found, or as Wall Street would say, it won't catch a bid.  This means that as the demand falls, the price will also fall until the risk-reward profile becomes attractive enough for investors to buy at market value.  With very rare exceptions, if the price falls, the yield must rise.

In the past, we have seen particular issues lose their bid, even as the market interest rate was rising, but eventually, they caught a bid when the yield rose to what we colloquially call "in the stratosphere".  Puerto Rico at 12 cents on the dollar and Greece at 40+% yield both come to mind. Of course, there have been single issues that never catch a bid, in such circumstances as default and/or hyperinflation.  

On the other hand, as the entire bond market experiences rising prices and falling yields, we will find more investors who will buy lower-yielding bonds, who in the past would not have bought a bond at the same low yield.  That’s because investors expect to make up the lost yield on the ability to sell the bond for a profit at a later date.  This transpired over the last 40 years as yields in America fell from around 20% to where they are today at 1.50-2.00%.

Most recently, as yields have plummeted around the world, investors have tried to catch a falling knife, bidding up the price of bonds while creating further downward pressure on the yield. Austrian bonds come to mind.  C-rated bonds yielding 4% will now catch a bid because a treasury yields only 1.50 % and a muni bond is not much better. 

We must also consider that current federal law requires certain financial institutions to buy the lowest yielding treasuries (really all treasuries), such as life insurance companies who are required to hold a very high percentage of treasuries, regardless of what the nominal yield may be.  Other financial institutions have the same or similar requirements, such as banks, investment banks, primary dealers, and the like.  This adds upward pressure to the price because there are buyers who are ready, willing, and able to comply with the law.  Upward price pressure, again, translates into downward yield pressure.

This all holds true even if rates fall below 0%, because of the laws requiring financial institutions to buy at any interest rate, as well as traders at the bond trading desk at the institutions thinking they can day-trade or swing-trade a greater return than what they'll lose on the negative yield. If they buy a new issue bond at -0.10%, they know they'll get a premium for it when the next round of new bonds will offer -0.20%, and the premium they receive to sell will be greater than the negative yield. This holds true even when including the premium they paid for it, because if they trade at a loss they lose their shirt (and their job).

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Disclaimers: The contents of this article are solely my opinion, and do not represent neither the opinion of this website nor its owner(s), nor any employer whether by contract or for wages.  ...

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Gary Anderson 6 months ago Contributor's comment

Nice take on bonds. Banks don't want nominal negative bonds and neither do individuals.

Mad Genius Economics 6 months ago Author's comment

Thanks for reading and commenting Gary. I appreciate your feedback and contribution to the discussion.

I don't think anyone wants negative yielding bonds because of the guaranteed loss. Imagine if I asked to borrow $10 on condition I have to pay you back $9.75. You might as well just give me the quarter and call it a day without having to risk the other $9.75 not getting paid back.