SHORT FIXED INCOME MARKET COMMENTARY, SEPTEMBER 2019

Negative Interest Rates Just Won't Work

In a series of recent tweets, President Trump mused, "The Federal Reserve should get our interest rates down to ZERO, or less, and we should then start to refinance our debt." He went on to describe the current situation as, "A once in a lifetime opportunity that we are missing because of ‘Boneheads'." Say what you will, but the President cannot be accused of being coy about asking for what he wants. Misguided perhaps. But coy, never.

One quick point that kind of grates on me: since 1985, all bonds issued by the U.S. Treasury have been non-callable. Meaning, the U.S. cannot "start" to refinance Treasury debt, but simply must reissue new obligations as others come due. To be fair, the President made his living in real estate where debt is often renegotiated, refinanced or defaulted. But to be even more fair, the President should be expected to know such things and, if he does know, to be more careful in his remarks. I'm not going to lie, Mr. Trump's history of frivolous comments about U.S. Treasury debt make me nervous.

So does all this talk of negative interest rates. When two- and ten-year U.S. Treasury yields plunged below 1.50% in early September on a combination of contraction in the ISM Manufacturing Index and further tariff sabre rattling, markets ratcheted up talk around the inevitability of U.S. rates going negative. Former Federal Reserve (Fed) Chairman Greenspan suggested it was "only a matter of time" before negative rates reach the U.S. Although, I'm not sure if he meant the Fed would eventually drive rates below zero or that the nearly $15T in negative-yielding foreign debt would inevitably drag down U.S. yields as well.

If he meant the Fed, I think Mr. Powell and company would be making a serious mistake. Conceptually, negative interest rates would spark growth through: 1) increasing business investment by lowering the discount rate of capital and improving net present value calculations for potential projects, and 2) convincing consumers to spend rather than save their hard-earned wages under the threat of losing a portion of those savings. I'm not convinced.

While I have never worked in corporate finance, the concept investment projects are primarily driven by funding costs seems amiss. Projects which only make sense at a very low discount rate are probably not the type to make companies meaningfully more productive or profitable. Issuing debt at low rates and buying back stock or raising dividends seems like a safer way for executives to keep their jobs. As far as charging for savings, negative yields seem more likely to cause angst among income-oriented savers,  translating into an even greater inclination to hoard money rather than go on a spending spree.

Distortions from negative yields go beyond capital allocation decisions and saving incentives. Pension assumptions will skew decidedly negative, stressing already underfunded obligations. Bank profitability suffers as well. In Europe, banks have been unable to grow their capital bases through earnings, which only inhibits the lending the European Central Bank is desperately trying to encourage.

Given all these negatives, why have current and former members of the Fed suggested negative rates are an appropriate and effective policy tool? Lowering rates is the primary weapon in the Fed's arsenal, and no central banker worth their salt would suggest they are ever out of ammo. Investors must believe the Fed is willing and able to act in times of economic or financial distress to avoid a collapse of confidence. Policymakers are probably inclined to say negative rates will work even if it is not fully believed. I also think Fed officials and investors are still suffering from post-traumatic stress from the Financial Crisis. And, in turn, are loathe to allow "zombie companies" and over-leveraged investment strategies to go under for fear of starting a negative feedback loop à la 2008.

2019 is not 2008, although investors and pundits are not above pushing that thesis in order to keep the central bank spigots wide open. The sense is at some point even those pushing the Fed to ease in a growing economy with 3.7% unemployment will acknowledge the negative interest rates just won't work. And if I'm wrong, well I guess I'm a Bonehead.

 

Sources

Bloomberg

Ben Hernandez, ETF Trends, Alan Greenspan: Negative Yields "Only a Matter of Time", September 5, 2019

Twitter @ RealDonaldTrump, September 11, 2019