Negative interest rates are unsustainable and once investors decide to stop paying for the privilege of holding government debt, a banking crisis could result, says James Grant.
The founder of Grant’s Interest Rate Observer was one of several speakers at the New York Society of Security Analysts (NYSSA)’ Annual Benjamin Graham Conference to remark on the ramifications of unprecedented loose monetary policy.
Central banks are treading in uncharted waters. Sidney Homer and Richard Sylla, the authors of A History of Interest Rates, found no instance of negative rates in 5,000 years. Now there are $11.7 trillion invested in negative-yield sovereign debt, including $7.9 trillion in Japanese government bonds and over $1 trillion in both French and German sovereign debt.
Grant posed a tongue-in-cheek question: “If these are the first sub-zero interest rates in 5,000 years, is this not the worst economy since 3,000 BC?”
This is not a bad economy by most measures. Household wealth in the United States has grown steadily since the Great Recession. If these gains were the result of greater productivity, interest rates would not need to stay at historic lows. Grant says they are “a sign of someone’s thumb on the currency.” Negative rates are propping up risk assets. He critiqued US Federal Reserve chair Janet Yellen’s touting of the bull market in equities as a sign of prosperity by alluding to Brexit voters.
“Asset prices have failed to pacify the world’s unprofitable voters,” Grant said.
The War on Cash
Investors have fallen into the trap of thinking that the future will be like the past, Grant says. The period of falling yields and rising bond prices that began in 1981 is entering its 35th year. He noted that a 35-year bear market preceded this. Yet the yield curve for Swiss bonds is sub-zero for the next 30 years, thereby implying that investors expect negative rates to persist for a long time.
Another reason to think rates must begin to rise: Bonds with negative yields are worse investments than cash. That has always been the reason for zero lower bound in monetary policy. So far, investors have been willing to pay for the convenience and security of storing wealth in banks and bonds, but if yields become sharply negative, some savers will no longer be able to accept guaranteed compounded losses. Then, conventional wisdom says, they will hoard cash, which returns 0%.
To maintain increasingly lower interest rates would require a “war on cash,” Grant said. He envisions a means by which the Fed would discourage and stigmatize using cash, and ultimately implement an unfavorable exchange rate on physical currency.
Central Bank Acrobatics
Central bankers have taken the evolution of currency from a measure of value to a macro-policy tool to, and perhaps beyond, its limits, Grant says. A federal funds rate below zero charges banks to store deposits at the central bank. These negative rates are passed on to depositors, which incentivizes them to spend rather than save. To avoid paying negative rates, banks and individuals buy bonds, so yields fall below zero when demand and price spike.
These “central bank acrobatics” create distortions, like inflated equity prices. Another example: Italian 10-year notes yield roughly 20 basis points (bps) less than US notes. If this is not evidence of the European Central Bank (ECB)’s currency manipulations, Grant said, then investors must expect “a return to the glory of Rome.” Even as the pound fell 12% after Brexit, 10-year gilt yields fell below 1%.
“Where is the pushback from the market?” Grant asked.
Yellen has said the Fed could set the funds rate below zero in the event of a recession. Grant put the odds of sharply negative rates in the case of a recession at “perhaps not 60%,” but noted a confidence in negative rates among central bankers. After the Great Recession, a near-zero funds rate and quantitative easing (QE), which raised inflation expectations, had already reduced real yields to below zero.
Though savers are yet to hoard cash in their mattresses, negative rates could have other consequences. Negative funds rates squeeze banks’ profit margins. Low enough rates could cause many to become unprofitable. Pension funds depend on bond yields to meet their payment requirements. Grant says it is now impossible for them to hit 7% return targets. Insurance companies invest their premiums in fixed income, and are “dying on the vine” according to Grant.
If interest rates rise due to inflation or pushback from the market, several countries could have difficulty coping with the higher costs of borrowing. Italian stocks tumbled after Brexit, indicating that investors may fear a debt crisis. Japan will have even more difficulty disposing of its debt. Japan has the highest debt-to-GDP ratio in the world at over 200%, in part due to Abenomics intended to prop up stock prices and inflation. Grant also thinks China’s wealth management products are a threat to default.
Gold: An Investment in Monetary Disorder
Grant acknowledged that gold is “the asset class of choice for calamity hounds,” but suggested that investors consider it. The case for gold, he says, has more to do with the state of money and credit than with Brexit. Grant characterizes the value of gold as the reciprocal of the world’s trust in central banks.
“Radical monetary policy begets more radical policy,” he said. “It seems to me, at some point, markets or voters will put a stop to this.”
If and when that time comes, investors will be looking for physical stores of wealth.
“The case for gold is not as a hedge against monetary disorder, because we have monetary disorder, but rather an investment in monetary disorder,” Grant said.