The Meaning of Negative Interest Rates

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So called “negative interest rates” have appeared with greater frequency in Europe and Japan.  It is not that individuals in these countries can borrow from a bank and get paid to borrow.  The negative rates concern governments and large, financially sound corporations.  Here is how they work:  A government issues a bond at a very low coupon –– that is, stated –– interest or attaches no interest to it at all.  Effectively, the government issuer promises the bond buyer to return at a future date only the money borrowed.  For reasons discussed below, these bonds become so popular that the price gets bid above the amount that the borrower (governments and solid corporations) promises to repay. These bond buyers then, if they hold the bond to maturity, will get less back than the premium price they paid for the bond.  That constitutes a negative interest rate.

The increased number of such foreign bonds has led to speculation whether, and when, negative-yield bonds might come to this country.  The answer is straightforward: not for a while and perhaps never.  The economic fundamentals that have brought negative interest rates and bond yields to Europe and Japan do not exist in the United States.  And until they do, if ever they do, U.S. interest rates will stay positive, if low.

The way to understand this is to look at the fundamental economic background in Europe and Japan and then to compare it with the United States.  There are two differences: cyclical conditions and more fundamental long-term factors.  I count four of the first and two of the second:

The Four Cyclical Conditions

2. Recession:  Recession, or the fear of, it always drives investors into quality sovereign debt (bonds and the like issued by governments) as a haven from stocks that will likely suffer in a recession.  Japan, which harbors almost half the world’s negative yielding debt, is in recession.  Europe has for some time shown signs of economic weakness and stagnation and seems to have entered a modest decline.  The United States economy continues to grow, though there are increasing fears here of recession.
3. Trade war:  While the trade war between the United States and China contributes to concerns about recession across the globe, it also has generated some fear that the value of the dollar will eventually decline, even though thus far it has held steady.  That prospect has convinced many to prefer Euro- and Japanese yen-based bonds, and to accept their negative yields in the expectation that their value will increase relative to the dollar.  This is called a currency arbitrage.
4. Monetary Policy: Both the European Central Bank (ECB) and the Bank of Japan have signaled their intentions to pursue extreme monetary ease. These policies could drive interest rates and yields downward and accordingly drive up the price of bonds, as I have described in this post.  In anticipation, investors have bought bonds in these areas, bidding up their prices so aggressively that they have created negative yields.
5. Momentum:  There is always a lot of momentum at work, especially in shorter-term market moves, not the least because much algorithm trading implicitly assumes that recent trends will continue, especially in the short run.  Prices of bonds have risen.  Many will buy bonds simply on the assumption that their nominal value will continue to rise, giving them an opportunity to sell at a profit even though they have purchased bonds that will lose these investors money if they hold the bonds to maturity.

Two Longer-Term Considerations:

1. The possibility of deflation: Japan has already experienced deflation –– defined as falling prices on goods and services.  In Europe, though there is still positive inflation, it is low.  In the U.S., Federal Reserve Chairman Jerome Powell has pointed out the unusually low rates of inflation, given that the economy is at full employment.  There is much talk both here and abroad that we have moved into a new normal where, for a number of reasons, inflation will remain quiescent regardless of economic fundamentals.  To many observers, this perspective, even in the absence of an explicit forecast for deflation, makes deflation seem much more likely.  Faced with potential deflation, nominally negative bond yields look less expensive in real terms, because the purchasing power of money will rise, providing a positive real return on the bonds even without any interest payments.  If such ideas strengthen in the U.S., the appearance of negative yields here will become more likely.
2. Long-term economic decline:  Bond yields, especially on low-risk instruments, should reflect the nominal return on all kinds of assets in the overall economy.  If the real economy is producing little nominal return on assets, why should financial instruments do any better?  In Japan, where there is very little growth in the economy, the general run of business is seeing no growth either, and the return on their assets is next to nothing.  It is little wonder, then, that Japan’s financial assets, bonds in particular, pay no return –– that is, they have negative interest rates.  Europe is beginning to look that way, too, at least large parts of the Eurozone. Indeed, limited returns in a general economy would also limit the tax revenues of any government, making it difficult if not impossible for that government to honor obligations that offered much positive return. Recent statistics indicate that the U.S. economy is far from such a position, but should its economy weaken, ideas about long-term decline will gain more traction and the prospect of negative interest rates will become more likely.

For the time being, Americans investing in dollar-based financial instruments have little to worry about on this score.  Nonetheless, we should be aware of the warning signs outlined here.