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Wednesday, 01 April 2015 02:00

 Only A Movie

This is a line from the "Exorcist", the horror movie from the 1970s. A young girl becomes possessed by the devil and the rest of the movie is the fight of good versus evil. The Exorcist was a movie that gave me nightmares for months. Interest rates have been at or near zero % for the last 6 years and that is bad enough. But lately, there have been numerous stories out that can cause other nightmares. The latest horror? Negative interest rates!!! Cue the scary, sinister music!

How in the world can we have negative rates? And who would EVER buy a bond with negative rates? Where are rates negative?

Throughout much of Europe, interest rates are negative out to 5 years maturity. That means you actually pay someone to hold your money. Are they Crazy?

Now there can be many reasons for the phenomenon, from regulation, to fear, to deflation, or even speculation. Regulation? Yes, the regulators have forced banks to charge for large deposits. This may backfire down the road, but it is the case here now. Fear? Yes, when investors see only risk and the alternatives are bad, they may think that paying a little is better than losing A LOT. Deflation? When prices are falling, there is an incentive to hold cash or cash substitutes. If prices are falling quickly, the negative cost of holding cash may be preferential to owning an asset that is losing value quickly. Speculation? If prices are falling, someone may be willing to buy negative interest rates if he believes that someone else will buy it even more dear.

Fear Deflation2Let's focus on the Fear and Deflation. For those of us raised in an economy where inflation has always been around, this seems silly. But, the last few years there have been periods of deflation or a lack of inflation for a myriad of reasons. Is it really so crazy to think about paying someone to hold our money? If I pay the bank for a safety deposit box, I pay them to keep my assets safe. In Europe (especially Germany and Switzerland) that is exactly what is happening. The fear of the Euro breaking up has investors scrambling to find something safe. As the Greece situation worsens and the fear increases of a possible break-up of the Euro, small losses are better than large ones. Now, the easy question here is, why not just hold cash instead? Why take the loss? If the amount is $500, the answer is, yes, keep it in cash. But, what if the amount is $500 million? Where do you keep that? Well in a bank of course, except now they have to charge for that privilege for regulatory reasons.

Deflation is the other major factor that could cause one to invest in negative rates. Bernanke was nicknamed "Helicopter Ben" because he said he would go up in a helicopter dumping cash dollars out if he thought he needed to fight deflation. We have negative rates here in the US if you were to buy some TIPS. (Treasury Inflation Protection Securities). TIPs are negative out to 5yr maturity, but the reason one invests is because they are afraid of inflation. But, in Europe they are facing real deflation similar to Japan for the last 20 years. And as I mentioned above, if the value of assets is declining, losing a small amount is preferable to losing a lot. You can see the effects of deflation by looking at how the value of the Euro has dropped. The Euro has fallen over 30% versus the U.S. dollar since 2008. As the $ has appreciated, the US imports deflation and Europe exports deflation...except they haven't exported enough! Their economy is still in decline.

Strategists in the US have been predicting higher rates in the US for some time now, so this may be a passing phenomenon. But with Europe and the Japanese economies faring poorly, it will be difficult for the US economy to ignore the rest of the world economy forever. The world economy could use an exorcist to rid itself of the horrible policies that have plagued it for the last 20 years. Or maybe, we all just close our eyes and repeat..."It's only a movie, it's only a movie!"

 

Ted Ake

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