Mayor: What do you mean, “biblical”?

Dr Ray Stantz: What he means is Old Testament, Mr. Mayor, real wrath of God type stuff.
Dr. Peter Venkman: Exactly.
Dr Ray Stantz: Fire and brimstone coming down from the skies! Rivers and seas boiling!
Dr. Egon Spengler: Forty years of darkness! Earthquakes, volcanoes…
Winston Zeddemore: The dead rising from the grave!
Dr. Peter Venkman: Human sacrifice, dogs and cats living together… mass hysteria!
Mayor: All right, all right! I get the point!
Ghostbusters (1984)

Happy 4th of July weekend! Some macro ‘blinding glimpse of the obvious’ blogging.

ZIRP is one thing, but it’s hard to get one’s head around how weird negative interest rates really are.

When deposit rates are negative, and you get charged to deposit money, cash banknotes are a more-or-less risk-free arb. If you can get paid to borrow, you can borrow an infinite amount, convert borrowings to cash, earn a risk-free return.

In practice there is a cost to storing, transporting, and safekeeping the cash. And then, the monetary authority can just refuse to convert more than some amount to cash per day, or take the economy completely cashless.

But it is still pretty nuts to have to pay to give your money to the banking system. It turns the whole logic of the banking system on its head, that they take your float and pay you partly in interest, partly in services like ‘free’ checking.

If it doesn’t pay for the bank to take your money, the whole business model of the Main Street bank goes out the window and can only be resurrected by further perversions of the natural order, like interest on excessive reserves, i.e., the Fed subsidizing the banks to keep taking deposits and stash them at the Fed. Not for nothing many of Europe’s largest banks are worth less than Silicon Valley unicorns.

There’s another important Econ 101 reason interest rates aren’t supposed to go negative. At a 0 interest rate, any project that makes a positive return becomes economical. And you would think there should be a pretty unlimited number of such projects.

In theory, razing Mount Everest1 so a few more Sherpas and yaks could travel faster and more conveniently between Nepal and China would be worthwhile. If you borrow all the money at zero interest rate, and you can get even $1 a day in revenue from that proposition, eventually you’ll pay off the debt, and continue to enjoy the more convenient yak-travel and toll revenue until the end of time.

And if negative interest rates mean you lose money by keeping it in the financial system, any marginally less money-losing project is viable. As long as a project loses less money than the negative interest rate, it pays to borrow and do it.

In the real world no one does that. Why not? Well, there’s what you might call a financial stability constraint. If you issue 10-year bonds, you want to do projects that you know you can probably refinance in 10 years even if the interest rate environment changes. So the Mount Everest project probably doesn’t qualify.

Maybe you want something that is economical even if you have to refinance in 10 years at historical average rates of say 5%. By my math, that means you still have a positive hurdle rate of 3.4% or so.

In practice that means there are diminishing benefits to borrowers of pushing interest rates lower. The yield curve is a whip, the Fed moves the handle, the long maturities typically react less depending on expectations of the longer-term policy and rate environment. The lower the rates, the more value is in the more distant cash flows whose value changes less at lower rates. Convexity increases as rates drop, which is good for bondholders, doesn’t help borrowers.

Cutting rates is always a 2-way street, it helps borrowers and hurts savers’ reinvestment income. It can bring some of that income forward in the form of bond appreciation…but worth remembering that the income stream of any bond held to maturity doesn’t change.

So when there are diminishing returns to the benefit that borrowers receive, and savers start feeling real loss aversion, with money being taken out of their pockets as an actual tax on liquidity, it could almost make you a Neo-Fisherian.

Neo-Fisherians are folks who think that beyond a certain point, lowering interest rates reduces demand and leads to deflation.

It would be a bit odd if printing more money, i.e. lowering rates to the point you get paid to borrow, makes money more valuable.

Normally I would reject that out of hand. But we’re not in Kansas anymore. We are most definitely through the looking glass.

My best guess is as rates go to zero, the stimulative impact goes to zero. Maybe it stays positive all the way to zero, but the stimulative impact could wear off before you get to zero and it could get a wee bit negative for all we know.

It shows how little we know, that people can argue about whether lowering rates is expansionary or contractionary. Once you go below zero, you’re in uncharted territory and all bets are off, it depends how it’s implemented, what kind of financial system you have left and if it still lets people borrow and make payments and allocate capital efficiently.

And yet, here we are, with negative interest rates out to at least 10 years in Germany, Japan, Switzerland. The market will actually pay the Swiss to take their money and dig a tunnel. If this keeps up, the Alps will turn into Swiss cheese.

God bless America, and stay tuned for more blinding glimpses of the obvious.

P. S. Investment thesis: bonds have value purely as a deflation hedge at this point. Monetary policy is exhausted, the world is heavily indebted, many governments would be find it politically hard to respond rapidly to a negative shock with fiscal stimulus. Therefore, the risk of a debt deflation spiral is out there. In that event equities, any growth and inflation-oriented investments would lose their value, and e.g. government bonds would be one of the few safe havens. Barring deflation, prospects for earning a real return on a negative-coupon instrument are…poor. Well, I did say it was ‘blinding glimpse of the obvious’ blogging.

I would add that I held this view since rates were in the 1% area…a 10-year 1% bond has maximum nominal upside of exactly 10% if rates go to zero (or held to maturity). So for a while now, the only reason to hold bonds was for liquidity/hedging purposes, and expectations of real returns would be unreasonable, barring deflation which would be the end of our indebted universe.

And negative rates are a very bad omen: they suggest investors have poor economic expectations, deflation fears or at least a strong desire to hedge against them, high risk aversion in the form of willingness to pay for liquidity.

Deflation means the $1 you owe is worth more than $1 a year from now. If you’re struggling to pay off debts, it will be even worse next year. That means you don’t spend, companies don’t invest, worsening growth and potentially leading to a debt-deflation spiral. In a heavily indebted world, deflation is death. Diminishing effectiveness of monetary policy as interest rates approach what used to be considered the zero lower bound makes it powerless to help, leaving fiscal policy as the only remaining lever.

Negative interest rates are the financial harbinger of end times. They tell us the natural flows of funds are not functioning. If you think the world might come to an end, own some government bonds, especially US bonds. If not, good time to borrow and invest (wisely).

<a name=”1”1</a> See Bernanke: “As Larry’s uncle Paul Samuelson taught me in graduate school at MIT, if the real interest rate were expected to be negative indefinitely, almost any investment is profitable. For example, at a negative (or even zero) interest rate, it would pay to level the Rocky Mountains to save even the small amount of fuel expended by trains and cars that currently must climb steep grades. It’s therefore questionable that the economy’s equilibrium real rate can really be negative for an extended period.”