The long and the short of negative interest rates

When I was young there was a list of things that would probably never happen: video phones, flying cars, The Beatles reforming, negative interest rates.

I guess no-one’s right all the time.

So, why have interest rates plummeted from the heady days of 1989, when we could get (or be charged) 17 per cent, to around 1 per cent (or zero for a deposit) now?

Over these past 30 years, we’ve had successive governments telling us what great economic managers they are, often using interest rates as part of their pitch, yet the economy is foundering.

What’s going on and how has it come to this?

If we look at short-term and long-term interest rates, we’ll see that there are two forces pushing these rates lower, albeit for quite different reasons.

The short

The short-term interest rate is essentially the price of money. The world’s central banks, including the RBA here in Australia, set short-term interest rates to change the level of borrowing and spending in their economy.

If the economy needs to be slowed, because spending and inflation are too high, they raise the short-term rate. If the economy needs a bit of a push, they lower it.

Since the Global Financial Crisis in 2008, every government around the world has seen the need to lower its rates regularly in an attempt to stimulate the economy.

So far, there’s not been much success. So little success, in fact, that in June 2014 the European Central Bank started to pay negative interest rates to commercial banks in return for accepting their money.

As the term ‘negative’ implies, they get back less than they put in. So, why would anyone do that?

The rationale is clear: to give the banks an incentive to lend their money to businesses and consumers to (hopefully) encourage investment and consumption.

The main aim of negative interest rates is to give the economy a prod as it’s unlikely to get a move on when banks are being conservative with their money.

The Eurozone cash rate is now -0.40%, while Japan, Sweden, Denmark, and Switzerland also have negative central bank interest rates.

In Australia we’re currently at a 1% cash rate but market speculation is that we’re headed towards 0.50% and possibly lower.

Despite the low rates, the stimulus doesn’t seem to be working. Economists and central bankers around the world can’t figure out why.

The long

As interest rates go all the way out to 30 years or more, you can plot them on a chart to see what’s known as the Yield Curve.

The yield curve is seen as a reliable gauge as to what the markets feel is the long-term outlook for an economy. That’s why the shape of the yield curve in various countries is a prominent talking point.

When inflation and economic activity are expected to be growing, the further you look into the future, the higher rates get. This is because lenders expect inflation to erode their future spending power, therefore they demand a higher interest rate as compensation.

When expectations for the future are pessimistic, interest rates out beyond 10 years tend to come down.

Recently they’ve fallen so much that the term ‘curve’ has become something of a misnomer!

This chart by Thomson Reuters shows the current government bond yield curves* for six countries:

Government Bond Yield Curve September 2019

*As not all governments have a 30-year bond, the chart presents the 10-year yield curve to offer a clear comparison.

 

As you can see, the USA has the strongest prospects and has been raising interest rates from historic lows for a few years now (although it did cut rates recently).

But what’s attracting much of the attention is the ‘shape’ of the curves. The fact that they’re all relatively flat indicates a subdued outlook for the future.

On top of the general decline in long-term interest rates due to lower economic activity there’s been a surge in demand for government bonds.

Interestingly, it’s been this demand for bonds that has pushed their yields lower and lower. So low, in fact, that around $15 trillion of global debt now has a negative yield.

Once again, as the term ‘negative’ implies, an investor in any of these bonds gets back less money than they invested.

There are several factors at play here:

  1. The US-China trade war has cast a shadow over the prospects for a near-term economic recovery.

  2. Equity investors, who have enjoyed strong markets boosted by the availability of very cheap money, are feeling squeamish about the risk going forward.

  3. The prices of bonds issued by quality governments have risen sharply as more and more investors look for a safer alternative to equities.

Bond yields were already low and the increased demand for them has pushed yields into negative territory.

You might reasonably wonder why an investor would buy a bond that’s guaranteed to lose money.

The answer is this: investors prefer the certainty of a small loss in bonds than the possibility of a larger loss in equities.

The negative yield is the cost of capital preservation, and it’s a price many investors are prepared to pay. It’s similar to paying an insurance premium. The safety and liquidity of government and highly rated corporate debt make them attractive investments in the current climate, even with the surety of a capital loss.

The long and the short

Different but related forces are pushing on both ends of the yield curve.

Interest rates will remain low until economies around the world show real signs of an upturn in output and employment.

With central banks cutting short-term rates and global investors forcing down long-term rates all the rest of us can do is wait for the economic cycle to pick up in order to get some yield back.

We can use that time to think about where we’ll park our flying cars.

 

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About the author:

Angus McLeod is a 25-year veteran of the financial markets, having spent 12 years as an equity portfolio manager. He holds a degree in Economics, a master’s in Applied Finance, and is a CFA charter holder and a CIMA® certificant. Angus is a lecturer in the Master of Finance course at RMIT University.

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