The Bizarre Mathematics Of How Negative Interest Rates Create Stratospheric Profits

There is an increasingly good chance that the United States could end up following Europe and Japan, and that the Federal Reserve could use its vast powers of money creation to force a move to negative interest rates.

If that deeply unnatural event happens, it will invert and distort the very foundations of investment pricing, in ways that are little understood by most investors today.

It will also - for a time - create an unnatural source of profits that most investors have no idea about because it has never happened before in the United States (and is still in the early stages in the United Kingdom).

Why should anyone care? Here are two reasons, as explored in this analysis:

1) The Federal Reserve using monetary creation to purchase bonds at negative interest rates would - for a time - mathematically unlock a deeply unnatural source of profits. This source simply does not exist with positive interest rates - but is more powerful than compound interest.

In the graphic above, the height of the purple bars represents the profits associated with one of the largest and longest running bull markets in bonds in U.S. history. As can be readily seen with the golden bars, those profits could be dwarfed by a move to negative interest rates.

2) Another bizarre side effect of the mathematics of negative interest rates is that those profits are unlocked instantly. So the inversion of the natural financial order that is negative interest rates could lead to the unnatural result of an investor making more money in a matter of weeks than they could ordinarily earn in decades with compound interest, all else being equal.

To understand how this could be, we will develop the XY graphic above. The right side of the graph, positive interest rates, is all of our experience with what most of us likely thought was the only natural and possible investment world, where wealth is steadily created over time by rational investors acting in their own self-interests.

When we cross the zero percent barrier and go to the left side, we find the twisted, inverted, unnatural world of negative interest rates, where the rational financial rewards for long term investing are replaced by irrational long term and unrelenting pain for many savers and investors - even while a new form of stunning potential profits can leap forward in time.

This analysis is part of a series of related analyses, which support a book that is in the process of being written. Some key chapters from the book and an overview of the series are linked here.

 Creating Future Wealth

For the understanding of how these extraordinary profits are created we need to go to the bedrock fundamentals of financial analysis, as professionals in the field usually learn when they are in college, but which many individual investors are not fully aware of. However, while they are based on that common foundation - negative rates lead to an inversion of reality that is so complete that even professionals with decades of experience can have trouble understanding the bizarre ways negative rates change investment returns and prices.

This means that we can't just look to the past and project it forward, which is what most people do when they try to make future investment plans. The issue is that this has never happened in the U.S. markets, and the profits are on the front end. Once it has already happened, for those who wait until then to learn - it may be too late.

Instead we need to go to the underlying fundamentals, which is why I wrote chapters 10, 11 and 12 in the free book. If you do have those chapters, it may be worth going back and reviewing them, otherwise I will do my best to explain the basics in a very compressed manner herein, so we can get to the implications for negative rates.

Underlying everything else when it comes the field of finance is a basic function that I call the wealth function. This is how future returns for investments are calculated, and it is also the foundation for how investment prices are calculated today. This is particularly true for bonds, but it is also the foundation underlying rational stock and real estate pricing. (As well as why bond, stock, and real estate pricing levels have all fundamentally changed as the Fed has forced every lower interest rates on the nation.)

Now if we take this wealth function as explored in detail in Chapter 10, and we multiply it times how much money we have to invest today then we get the "future value", how much money we will have in the future if we invest money today at a given rate for given period of time. The most common term for this with the general public is compound interest, but the formula applies to a lot more than just interest payments.

How it works is illustrated above. What we have is an exponential function that grows much stronger with higher rates, and longer periods of time. For instance, if we look at the average yield for 10 year Treasuries from 1962 to 2000, that was just over 7%, and if we put that into our future value formula for 30 years, that shows that we will earn $661 in interest over 30 years, as shown with the rightmost red bar.

(There is no need to actually run any numbers or use any equations to follow this analysis, I will do all of that and illustrate it for you. That said, for those who wish, I'm keeping the examples simple enough - even the esoterics of negative rate price changes - so that the numbers can easily be run and explored on your own using any spreadsheet, hand calculator or even with the calculator app on your phone. As an example, using the future value (FV) formula of ((1 + i) ^ n), ((1 + .07) ^ 30 = 7.61, with a starting investment of $100 that would mean a future value of $761 at a 7% rate over 30 years, of which $100 would be the return of the investment, and $661 would be interest earnings.)

The purple bars are compound interest at a 3% interest rate, and over 30 years those would be $143. This much lower interest rate is more in the range of what we have experienced since the Federal Reserve began implementing its aggressive low interest rate polices in 2001, and shows that the cost for investors is a 78% reduction in the ability to build wealth over the long term using the reliable "magic" of compound interest.

(The numbers are ((1 + i) ^ n), (1 + .03) ^ 30) = 2.43, $100 X 2.43 = $243, $243 - $100 = $143 in future interest earnings.)

The golden bars are compound interest at a 1% interest rate, and over 30 years those would be $35. This is more comparable to what long term government bond rates have been since the Fed slammed short term interest rates down to 0% in the attempt to contain the economic and market damage from the pandemic and shutdowns. So the price of the Federal Reserve's extreme measures - which they are currently pledging to maintain until at least 2022 - is a 95% destruction of the ability for investors to create wealth over the long term via compound interest.

(The numbers are ((1 + i) ^ n), (1 + .01) ^ 30) = 1.35, $100 X 1.35 = $135, $135 - $100 = $35 in future interest earnings.)

This ties in very closely to what we went through in Chapter 17 (link here) which is the true cost of the national debt for investors and that is the catastrophic collapse of the ability to reliably create wealth through compound interest over time. This is a pervasive problem for all savers that is likely to only grow worse with the current explosion in the national debt.

Profits (Or Losses) Today

The next step, as explored in Chapter 11, is to use the wealth function to travel the other direction in time, and find the price we will pay today for a given cash flow in the future (i.e. the present value). This is tremendously useful because it tells us exactly how much money we can make - or lose - if interest rates change, and understanding how this works is the key to understanding the counterintuitive ways in which negative interest rates can create extraordinary profits with blinding speed, and with a power that can even exceed that of compound interest.

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Disclosure: This analysis contains the ideas and opinions of the author. It is a ...

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