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Negative Real Rates Show Yield Trade in Bubble Territory

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By EconMatters  

 

No Financial Crisis

 

This is one of my main criticisms of central bank policy, especially the last three years when there was no financial crisis but all the central banks continued to keep interest rates at recession era levels which has incentivized inappropriate uses of capital allocation, and this money being used for yield arbitrage plays would be more beneficial to sustainable growth projects and overall growth in the economy if interest rates were normalized. 

 

ECB Rates Too Low – Deflationary Capital Allocation Incentives

 

We see the pernicious aspects of below normal interest rates; the lower they go the more inappropriate and actually deflationary aspects in some cases of how investment capital is allocated. Take for example, the recent ECB measure to lower their equivalent Fed Funds Rate from 25 to 15 basis points, what did this incentivize? It incentivized a bunch of capital to run into European Bonds which were already at recent historical lows and chase more yield plays, so much so that the German short term debt up to two years has even gone negative on real rates.  

 

When you have investors flocking to investment choices all in an effort to take advantage of ridiculously low borrowing costs, really 15 basis points, more time and energy is spent on paper or in this case electronic arbitrage capital allocation strategies, that could better be spent in other areas of the European economy which actually promoted business development projects with real returns, and not more electronic arbitrage plays where all the capital stays locked up in financial markets and does no good for the economy at large, it creates no jobs in Europe!

 

Japan is Prime Example of the Curse of a Low-Rate Strategy

 

We see it in Japan, low rates for a prolonged period of time are deflationary in a sense because they encourage the wrong types of investment choices, strictly financial yield and carry trades instead of alternative and more productive capital allocation in terms of small business loans and business development projects.

Normalized Rated Get Rid of Many Non-Productive Capital Allocation Strategies

 

Normalized rates lead to real lending because the banks realize that they can no longer do these stupid yield arbitrage finance ‘gimmickry’ plays and must find real means of making money, i.e., make loans to businesses and produce real growth in the economy.

 

Read More >>> The Bond Market Explained for Mohamed El-Erian

 

Corporations Need Real Growth When Stock Buybacks are no Longer an Option

 

Furthermore, corporations also play a role in this because they no longer think gee I can borrow so cheaply let me borrow at these absurdly low rates and buy back stock, low rates for psychological reasons, and I mean rates at such abnormally low levels, actually affect the psychology regarding how capital is used by corporations. It shouldn`t make a difference but it sure does, a healthy interest rate almost mandates a healthy investment return and a productive use of capital by corporations. 

 

You sure don`t see corporations borrowing and loading up on debt to buy back stock when interest rates are higher! It is almost as if low rates incentive having little respect for the value of money, where with normalized rates respect for capital and the value of money is increased. I sure notice this correlation effect, when a corporation doesn`t think about buying back stock to make their EPS number look better, then they have to look for alternative ways to make their stock attractive to investors and make their numbers. This leads to more focus on growing the business, so then borrowing goes to organic growth and business development projects that add real economic might in the form of ‘additive effects’ to the economy. 

Central Banks can Promote the right kind of Capital Investments

 

This is how central banks can incentivize the right kinds of behavior by corporations and investors which add real sustainable growth to the economy by raising interest rates, and thereby raising the importance and value of capital. This leads to real capital allocation strategies instead of what we have today which negative real rates are illustrating via the incessant and over-reaching for yield in all areas at the expense of more productive uses of this same capital.

Zero-Bounding Rates is not the Answer for Real Growth

 

The ECB needs to learn the lessons of Japan that actually raising interest rates instead of lowering interest rates once you cross the 50 basis point threshold is actually simulative for growth by better incentivizing the right kind of capital investment in the region to more productive means. The proof is in the pudding: How long was the ECB rate at 25 basis points, how long under 100 basis points? And what was the growth in the EU over this time?

 

Basically nonexistent, once you cross and stay below the 50 basis point threshold, a central bank is actually doing more harm to their economy than good, maybe at first blush it seems paradoxical in nature, but if you examine some of the negative side effects of zero-bounding rates for an extended period of time it starts to make sense.

Once a certain interest rate threshold is reached, ‘zero-bounding’ rates for an extended period actually stunts economic growth and central banks need to come to grip with this monetary reality! Anytime there are negative or even close to negative real rates for bonds that is a sign that central banks need to change policy, they are in a sense reinforcing the very thing they are trying to avoid, they incentivize an over-reaching for yield at the cost of real growth, and this is deflationary, as it lowers the value of money. 

 

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Fri, 08/22/2014 - 01:29 | 5128693 hedgiex
hedgiex's picture

Voodoo Economics to believe that rigged markets still work to deliver price discovery. What exactly is inflation/deflation with manipulated data, unsustainable debt ?

If you want to play/tade, you respect those with hands on the lever of the printing press and ignore their rhetorics on wage growth, etc. Labor is just commoditized digitals and the writer is still not getting it. Economics is a belief system like a religious doctrine and you get more entertainement out of porns. Econs is irrelevant within present contexts.

If you do not want to play/trade, relax and watch the circus just making sure tht you are way behind the queque when the unending shows morphed on to other toxics. There is nothing to learn form the same clowns in EC/Japan past and present as their paradigms are not based on beliefs of sustainable econ growth (defined as growth with social justice for their people).

Thu, 08/21/2014 - 22:49 | 5128343 Mercantilist
Mercantilist's picture

Sure, you are right, but this ship has sailed....

Japan is too indebted to raise rates....

The US is probably too indebted to raise rates...

Most of the EU nations are too indebted to raise rates...

What happens to sovereign credit, EU budget deficits, US budgets deficits....God, Japan budget deficits!  All would take significant hits from increased interest rates on their government debt.

In theory you are right; higher rates are part of normally functioning economy.  But the current reality is that debt load created by our debt based monetary system has reached the point of no return...

We all know fiat money systems never work - while the post Bretton Woods system has appeared to work for a long time, its really just like a volcano, simmering below the surface there is lava ready to explode despite the fact that above the surface everything looks great - until that moment when it doesnt.   The good news is that volcano's usually give us warning signs before the go "boom."   Oh, wait...do we have any warning signes right now?   

Thu, 08/21/2014 - 22:45 | 5128342 Mercantilist
Mercantilist's picture

Sure, you are right, but this ship has sailed....

Japan is too indebted to raise rates....

The US is probably too indebted to raise rates...

Most of the EU nations are too indebted to raise rates...

What happens to sovereign credit, EU budget deficits, US budgets deficits....

In theory you are right; higher rates are part of normally functioning economy.  But the current reality is that debt load created by our debt based monetary system has reached the point of no return...

We all know fiat money systems never work - while the post Bretton Woods system has appeared to work for a long time, its really just like a volcano, simmering below the surface there is lava ready to explode.

Thu, 08/21/2014 - 21:57 | 5128197 tony bonn
tony bonn's picture

fekete has covered much of this ground, but it is good that a few others recognize the destructiveness of capital as a byproduct of artifically low rates. it is the hallmark of a kleptocracy. not only does it breed bad investing, but it stirs the coals of war. the us would implode with higher rates - they will never rise until the current totalitarian regime is destroyed. that will only occur when interest rate swaps incinerate.

Thu, 08/21/2014 - 21:46 | 5128148 disabledvet
disabledvet's picture

Again..."fighting the tape and sentiment."

Folks who have shorted looked like Kingmakers last fall...now they're covering the "worst of the worst" (the thirty year) and are getting absolutely incinerated.

This is not to say "go hog wild and buy zero coupon treasury bonds"....just saying as this debt matures the investor is making a killing while the short seller is having to pay that interest expense.

Good luck hedging that currency risk as well!!!!

This clown simply is ignorant of the History of Economics as it relates to Western Civilization. Division of labor, mass production, creation of a National Debt...the list is long and extensive and can be covered by playing a simple computer game...let alone a 300 level undergrad course in pretty much any US University.

The most important point from the US point of view is that you WANT to be the debt issuer. The mistake that "two speed Europe" IS making today and Japan still is making three decades on now is that they're reigning in consumption through "forced savings" just like the USA did when it had its Great Depression.

Sure it's good for the value of the money (until you have the nuke meltdown or Economic War with Russia) but the bottom line is with this much carry in the yield curve plus a MASSIVE amount of Federal stimulus (Total War in the Middle East) and you have in the USA a stupendous production boom. Energy prices have collapsed, housing is going nowhere...silver is flatlining and gold is rolling over.

Once you start ramping up the "value added" through the means of production you can create ENORMOUS amounts of value in that production. With the dollar still obscenely weak "good luck Europe."

Input costs due to the collapse in coal prices...and now Teslas...is wringing out the speculative excesses of the W Years...us you're minting money from the huge explosion in energy production itself.

The "value" in that "value chain" IN THEORY could be worth tens of BILLIONS. A good proxy for this TOTALLY INSANE BULL is called ORB...launching rockets with striking regularity from Wallops Island, Virginia. If meteor mining starts being realized the entire metals complex will be absolutely annihilated.

And obviously you have Lockheed/Martin and Space X all jumping on the "space bandwagon" using NASA's superb mapping, guidance, tacking and communication satellite systems which basically they have a monopoly over for probably the next hundred years.

We'll find out more when Japan launches Hyabussa II this fall.

For the record "you're bringing back refined product" if these missions work out. There is no problem with the infrastructure however. It's taken about three decades...but the plan was a very good one from the start.

We do have a Space Station already up there. The moon is only three days away.

Thu, 08/21/2014 - 19:54 | 5127754 Pareto
Pareto's picture

yeah.......this statement "they incentivize an over-reaching for yield at the cost of real growth, and this is deflationary, as it lowers the value of money. ...." doesn't make sense to me.  ZIRP may be price deflationary but that doesn't lower the value of money (i.e its purchasing power), it increases the value of money!  all else equal.  Prices falling means the same dollar buys more stuff.  But this is moot since ZIRP is not delfationary - it is inflationary (i.e increasing money supply).  Prices are rising  for the stuff that I need, and falling for the stuff that I don't.  Farmland, cereal crops, live cattle and calves, farm machinery - no price deflation there - nuu uhh.  Housing - average prices most everywhere are holding record levels or close to.  ZIRP is not, in my opinion, deflationary as cheap money finds or seeks out some return or store of value - expenditures on stuff that would never be made were real rates to be something north of 2%.  So, not sure what econmatters is saying here.

Thu, 08/21/2014 - 21:17 | 5128063 disabledvet
disabledvet's picture

Are you a farmer?

Let's start with that and go from there...

Thu, 08/21/2014 - 18:49 | 5127424 himaroid
himaroid's picture

Inflation is self defeating. Take a look at commodities over the past couple of weeks. Deflationary depression coming. Better quit while you are ahead. The coming rush to "safety" will cause negative nominal yields while still earning a real yield.

Thu, 08/21/2014 - 19:13 | 5127541 negative rates
negative rates's picture

You can run, but you can not hide, Jonney.

Do NOT follow this link or you will be banned from the site!