As of the writing of this post, we have negative interest rates in Germany, Switzerland, France, Japan, and the Netherlands. While this might seem highly unusual at first glance (and is in the government bond markets), by the end of this post you will see how prevalent this negative interest rate concept is not only in the markets, but in your personal financial situation. I call this the “pervasive wolf in sheep’s clothing.”
Think of government bonds as a safe version of an “I Owe You” you might have with a friend. The government needs to raise money for whatever reason (some capital project or ever bloating expense sheet), so they issue bonds in an open market where the purchaser is lending them money with the promise that it will be payed back plus a small amount of interest.
These investments are thought of as a safe haven with very little risk because the repayment is backed by the full faith and credit of the issuing government. This might sound funny, but it means that even in the worst case scenario governments have the unique ability to print money to pay back their debts. So if they don’t have the cash flow readily available at the time of maturity, to make good on their bond debt they can print more paper and solve the problem. For this reason, government bonds are a popular investment and staple in many investment portfolios.
So if it makes sense to lend a government money when you get some interest in return, why on Earth would anyone engage in this transaction if the government is paying a negative interest rate? The textbook answer is safety, but there is another sneakier incentive that many do not realize is happening.
Flight to Safety or Something Else?
The concept of paying someone to keep your money safe is not all that unheard of. An investor might look at the current dynamic of the capital markets (stock, bond, derivative, real estate, etc…) and see the recessionary writing on the wall. Or, in a simplified scenario, look at their government issuing a negative interest rate bond as an indicator of what is to come and think, well, I can park my money in this safe haven and lose a little, or I can keep it invested elsewhere and risk losing much more.
But it’s not just bonds where this is happening. Negative interest rates have also permeated the banking landscape where UBS Group AG plans to charge an annual fee of 0.6% for some wealthy clients to hold their money. So it’s no longer just bond holders paying for safety, it’s also bank depositors.
What you might not realize is we do this, and have done this type of thing for a very long time. Joe Weisenthal a journalist for Bloomberg Business Week articulates it clearly when he says, “it’s important to remember that money in the bank isn’t really something you have. It’s something that you are owed. When you log into your bank and see that you have $10,000 in your savings account, what that means is that your bank owes you $10,000. And where does the bank get the money to pay you? From the entities that owe the bank money. Maybe the bank holds government bonds (in which case, the state owes it money) or it holds its money in loans to households and businesses (in which case, the private sector owes it money). You get the idea. In other words, to store money at a bank requires the existence of some other borrower who will pay the bank. As such, just as you’ll pay more to store grain when grain is abundant and warehouse space is scarce, you have to pay more to hold money when savings are abundant but demand for borrowing is scarce. This is the world we have today.”
While his point is well taken, what I want you to understand is the concept of negative interest rates is even more pervasive, and sneaky, when you take into account inflation. You might be thinking, well this is not something I have to worry about because the savings account at my bank pays me 1%. Wrong! Inflation has been fluctuating between 2 and 3% for the last few years, so if you have cash sitting in a savings account earning 1%, and inflation is at 2.3%, you are paying a negative interest rate of -1.3%. This is the wolf in sheep’s clothing that steals your purchasing power. And very few people realize it because they see small interest amounts being paid to them.
Other Incentives for Negative Rates
There is another reason a government would be willing to push negative interest rates, and it too flies beneath the radar for many. While central banks will not come right out and say this, a primary factor for issuing bonds that will not pay back the principal in full is to incentivize people to invest in riskier assets that help propel a slowing or stagnant economy. Economics 101 tells us the formula for the U.S. GDP is GDP=Consumption+Investment+Government Spending+Net Exports. So increasing any of these variables should increase GDP growth which is the primary measurement for an economy.
The investment variable is what we are looking at here, and by incentivizing people to reallocate capital to things like real estate, small business ventures, private equity, and the more standard stock and bonds markets, the government is pushing individuals to riskier markets with the goal of increasing GDP. If these investments pay off, it is likely the consumption variable will also increase, which means more tax revenue and increased government spending. You can see how these are closely intertwined and would create the result a governing body might desire.
A Word of Caution
While incentivizing people to take more risk by creating a negative interest rate environment for both Treasury bond holders and bank depositors, these world governments have effectively forced more risk into the financial lives of the people. We know from past market cycles that people who have excess capital to invest get richer and richer when recessions occur, as they go in and buy assets at fire sale prices when everyone else is forced to either sell or hang on for dear life until things recover over the next few years. Warren Buffet is famously quoted for saying, “be fearful when others are greedy, and greedy when others are fearful.”
This concept should be taken to heart. If the masses are being driven to riskier assets (being greedy), we should be careful to monitor the environment and stay away from excessive risk taking. So if you are concerned with negative rates eating away at your purchasing power (bank deposits) or worried about macroeconomic forces affecting your investments, schedule a meeting with me. There are many solutions that alleviate these risks and can provide peace of mind. If this is something you would like to discuss, contact me here.
References
Picture credit: Steve from Pexels
UBS’s Rich Clients to Feel Negative Rates as Fees Extended. (2019, August 6). Retrieved October 10, 2019, from https://www.bloomberg.com/news/articles/2019-08-06/ubs-to-charge-wealthy-clients-for-euro-accounts-above-500-000.
The Non-Weirdness of Negative Interest Rates. (2019, August 8). Retrieved October 10, 2019, from https://www.bloomberg.com/news/articles/2019-08-08/the-non-weirdness-of-negative-interest-rates.
Consumer Price Index. (2019, October 10). Retrieved from https://www.bls.gov/news.release/cpi.toc.htm.