Negative interest rates
From the August 2019 print edition
I tend to focus on what’s going on in the North American economy. This is understandable. I live in Canada and the majority of my equity investments are headquartered in the U.S. There has been a great deal of discussion lately about interest rates, and whether the Bank of Canada and Federal Reserve
should be cutting them. At the most recent meeting of the Bank of Canada, rates were held steady. There is a broad consensus that at the next meeting of the Fed, rates will be reduced by 25 basis points.
But what is happening in Europe right now is much, much different. Interest rates are actually negative. This is almost unbelievable to someone like me who got his grounding in the time value of money (which is what interest rates are really all about) from watching Popeye cartoons as a young boy. There was this character, Wimpy, who famously and frequently said: “I’d gladly pay you Tuesday for a hamburger today.”
Wimpy understood the time value of money which means he understood interest rates. Give me a hamburger right now and I’ll pay for it in the future. This implies that there will be no interest charged on the money that is owed, which is one heck of a deal!
Back to Europe and negative interest rates. If I can flip Wimpy’s saying to explain what’s going on, it would go as follows: “I’d gladly pay you immediately and get that hamburger next Tuesday!” Negative interest rates mean that I pay €1,000,000 right now for a debt instrument and receive less than that in the future! And this is not an isolated phenomenon. Negative interest rates pertain to approximately $13 trillion-worth of government debt.
We saw negative interest rates 10 years ago. In the credit crisis of 2008–2009, there was understandable fear about the solvency of major financial institutions. It didn’t make sense to hold billions of dollars in liquid cash-like assets in a bank that could go bankrupt, which would mean that you might get back only pennies on the dollar. It was preferable to hold government-backed securities (which is what treasury bills or government bonds represent), even if the return was negative. At that time and in that particular context, negative interest rates could be justified. They are harder to understand
Harder, but not impossible. There is another way to interpret negative interest rates and it starts with an understanding of how, at least theoretically, nominal interest rates are established in the first place. “Nominal” interest rates include an inflation component. When you walk into a bank and you see GIC rates posted on a wall, these are nominal interest rates. When that same bank quotes a five-year fixed mortgage rate, this is also a nominal interest rate.
Expressed formulaically, it looks like this: nominal interest rate=real interest rate+inflation. Therefore, if inflation is three per cent and investors require a real return of two per cent, then the nominal interest would be five per cent.
OK, now we’re seeing that, in Europe at least, nominal interest rates are negative. So let’s re-write that equation: nominal rate (-1 per cent)=real rate+inflation.
To make the equation work, either the real rate and/or inflation could be negative. I’m going to focus on inflation and why negative interest rates could become the new normal.
I believe that after 20 years of economic stagnation, the developed world is on the cusp of a productivity boom that will dwarf what we saw over the 1980s and 1990s. Between artificial intelligence (AI) and robotics, manufacturing is being radically transformed. I recently met with the head of a private equity firm that specializes in these technologies and he described visiting a plant in the suburbs of Toronto. It was a huge location—several football fields would have fit comfortably in it, production was humming along … and he could have counted the number of employees on both hands. This is profoundly anti-inflationary. Robotics is transforming manufacturing while AI is transforming the service sector and productivity is in the process of going through the roof!
Yet at the same time, it is my belief, and even fear, that real economic growth will be tepid. The public sector continues to grow at the expense of the private sector. We will continue to treadmill more and more young people in useless college and university degrees, wasting their time and burdening them with debt. Putting this together means anti-inflationary pressures combined with tepid economic growth and interest rates should be negative.
And if the central banks in North America are smart, they’ll see the writing on the wall and cut rates sooner rather than later. SP