I explain to mrs_horseman the mechanics of negative interest rates.

 

If your only tool is a printing press, every problem is deflationary.
-hedgeless_horseman


There was an interesting article on ZeroHedge this morning, with some great comments from y'all.

Entire German Curve Drops Below Zero For First Time Ever

https://www.zerohedge.com/news/2019-08-02/entire-german-curve-drops-bel…

It is difficult for most people to wrap their heads around negative interest rates.  I have made several attempts at explaining the phenomenon, most recently in a conversation with the lovely mrs_horseman, while enjoying a wonderful Monsoon cocktail on the front porch swing during a hot and humid Texas evening.  

Allow me, dear ZeroHedge readers, to present to you my very own invention, the wettest of all martinis, for the hottest and most humid of days, the Monsoon.   

https://www.zerohedge.com/news/2019-06-03/alcohol-my-yoga-baby

First, I said, let's review the basics of what a bond is, and how it functions.  

A bond is simply a loan agreement between a borrower and one or more lenders.  It has an initial loan amount called the par value, an annual payment amount called the coupon, and a date called maturity, when the loan is to be paid back in full.  To keep the math simple, let us use the following for our illustration:

Borrower:  Wonder Marital Aids, Inc. (WONK)
Par Value:  $10,000
Coupon: $400 per year in $100 quarterly payments
Maturity:  7/31/2029 10 years from issuance

From this information we can calculate the initial interest rate.  Pay attention, as this calculation is important, if you want to understand negative interest:

$400/$10,000 = 4.00%

So, when the bond was issued last month, lenders gave WONK $10,000 for each bond they wanted to purchase.  In exchange, WONK agrees to pay the owner of the bond, which may or may not be the initial buyer, $100 every quarter, and also pay back the $10,000, in ten years.  So, over the duration of the bond, the borrower is obligated to pay:

$400 X 10 years = $4,000 in interest, plus $10,000 at maturity, or $14,000.

Thus far, what we have covered is objective.  It is just math.  Now, we need to talk about how the bond market is supposed to work, which is subjective, by definition of the term, "market."  

Often times the lender does not hold the bond until maturity, but rather sells it in the marketplace at a price that is subject to supply and demand.  For example, let us imagine that one year has passed since issuance.  Initially, the rating agencies gave these 10 year 4% WONK bonds an A rating.   However, WONK's vibrator business is really humming!  Wall Street analysts all agree that WONK should have no problem making its payments to the bond holders, and have raised the rating to AA.  In theory, higher risk borrowers pay a higher interest rate, so with WONK's risk of default decreasing, the bonds should trade at a lower interest rate.  Said another way, lenders should be willing to pay more for a safer investment, so with WONK's risk of default decreasing, the bonds should trade at a higher price.  

Keeping the math simple for illustration purposes, let us say that $10,250 is the new market price at which an investor buys the AA rated WONK bond, which now pays a 3.90% interest rate.

$400/$10,250 = 3.90%

However, if WONK's business wasn't doing so well, and Wall Street downgrades it to BBB, then an investor might only be willing to pay something like $9,750 for the bond, which will then pay a 4.10% interest rate.

$400/$9,750 = 4.10%

It is easy to see why the interest rate and price of a bond move in the opposite direction, like a teeter totter.  It is just math.

Next, let us take a look at a different bond, a hypothetical sovereign bond, which is a fancy term for government debt.  The government of The People's Republic of Oceania has elected to pay for the healthcare services of yet another group of voters.  However, the PROG government has no way of paying for this new entitlement, so they must borrow the money by issuing more PROG bonds. 

Borrower:  People's Republic of Oceania Government (PROG)
Par Value:  $10,000
Coupon: $100 per year in $25 quarterly payments
Maturity:  7/31/2029 10 years from issuance

$100/$10,000 = 1.00%

$100 X 10 years = $1,000 in interest, plus $10,000 at maturity, or $11,000.

Let us imagine that one year has passed since issuance.  Initially, the rating agencies gave these 10 year 1% PROG bonds a AAA rating, because The People's Republic owns a printing press, so they can always print more money to pay off the bondholders.  

However, Oceania's economy isn't really doing so well.  Fortunately, the printing press still works, so the PROG bonds keep their AAA rating.  

The PROG economists and bankers all agree that the problem with the PROG economy is that there is simply not enough liquidity, and therefore the solution is, and must forever be, more liquidity.  

So, they create more liquidity, which is just a euphemism for money, by creating more sovereign debt.  For a detailed explanation of this fascinating process, read the book, The Creature from Jekyll Island: A Second Look at the Federal Reserve.  However, it is a good idea to have a clear mind when doing so, meaning no Monsoons, as so many of the concepts explained are counter intuitive and confusing by design.  

5.  Make a commitment to not use mind-altering substances for 90 days.  If you fail, go to an AA meeting and restart the 90 days.

6.  Read, The Creature from Jekyll Island: A Second Look at the Federal Reserve - 5th Edition, by G. Edward Griffin.

https://www.zerohedge.com/news/2016-01-06/hedgelesshorsemans-revolution…  

The interesting thing is what, exactly, the central bankers are doing with much, if not most, of this freshly created money.  They are buying bonds, including their own nation's bonds, and other nation's as well!  For example, the Federal Reserve currently owns $2,080,700,000,000 of United States Treasury debt, for which it is also the lender, and for which the US taxpayer is the de facto guarantor.  

 

The brighter economists refer to this scheme as, "jerking the dog off to feed the cat."

So, we can calculate what happens when the PROG bank buys PROG bonds.  This increased market demand causes the market price of the PROG bonds to increase.  For example, keeping it overly simple to fit on the back of the cocktail napkin, let us say they now trade at $11,500 with 5 years left to maturity.  

$100/$11,500 = 0.0087%

Still a positive interest rate, right?

Not exactly.  

$100 X 5 years = $500 in interest, plus $10,000 at maturity, or $10,500.

Because the owner of the bond pays $11,500 but only receives a total of $10,500, the return is a loss of $1,000 over 5 years, or a negative yield of -1.80% compounded annually, if my napkin math is correct after my second Monsoon.  

In summary, the central bankers create demand for their own government debt, by buying the very same government debt with even more freshly created government debt, artificially raising the market price, and mathematically lowering the rate.   

Yahoo! Chart

If you think that this cannot end well, then we are in agreement.  Plan accordingly.

If you liked this explanation of negative interest rates, then consider this article on inflation and the rising stock market: 

What can we learn by looking at a carnival, a casino, and the stock market as simple-closed systems?

https://www.zerohedge.com/news/2017-01-13/what-can-we-learn-looking-car…

Peace, prosperity, liberty, and love,

h_h

 

PS:  No, I didn't use the same crude examples with my sophisticated wife.  Just trying to add a bit of humor to a dull topic.