I was talking about the bond bubble earlier this week.
Seems I’m not the only one who’s a bit worried. Bill Gross, founder of Pimco (now at Janus Capital), tweeted “Global yields lowest in 500 years of recorded history… This is a supernova that will explode one day.”
Aside from making the pedantic point that a supernova is itself an explosion (according to my limited knowledge of astronomy at least), I find little to disagree with here.
The big question is – when will the bubble burst? We discussed that on Monday.
But in the meantime, it’s worth asking – what damage are negative interest rates doing to our financial system?
The dangers posed by negative interest rates
The bond bubble is real. It’s also incredibly dangerous to the financial system.
According to Goldman Sachs, “an unexpected one percentage point rise in US Treasury yields would trigger $1trn of losses, exceeding the financial crisis losses from mortgage-backed bonds,” reports the Financial Times.
This is the stuff that our pension funds, our banks, our institutions are invested up to their necks in. It’s not very reassuring really.
But let’s put that aside for the moment. The idea that interest rates might rise at some point in the future is quite scary. But it’s not as scary as what low and negative rates are currently doing to our economy.
As Larry Fink of BlackRock put it in a shareholder letter in April: “Not nearly enough attention has been paid to the toll these low rates – and now negative rates – are taking on the ability of investors to save and plan for the future.”
It’s extremely hard to get your head around exactly how disruptive negative interest rates are. That’s partly because – as a private investor – you probably haven’t been directly exposed to the consequences (or the benefits, for that matter). For a start, rates in the UK are still (just) positive. Secondly, even in countries where interest rates are negative, retail investors have (in most places, though not all) not seen that feed through to their own savings accounts.
However, the big players have been hit. And it’s instructive to see how they’re reacting. At an institutional level, banks across Europe are trying to work out what is the least expensive way to bury their cash in a big hole.
As my colleague Merryn Somerset Webb pointed out this week on her blog, Commerzbank is looking at how practical it would be to rent vaults and store its own cash rather than be charged 0.4% a year to store it with the European Central Bank. Munich Re has been doing the same.
This is the “zero-bound” problem. The point of turning interest rates negative is to force banks (and anyone else with cash) to lend it or spend it. But this only works if you can forcibly tax the cash. The easy way to avoid negative rates is simply to stick the cash under the mattress.
And of course, this is why central banks are so keen to ban cash – if all money is digital, then you can’t avoid the negative interest rate tax.
Beyond the zero-bound problem
But there’s a problem here that goes well beyond the “zero-bound” issue. And that’s about the message that negative rates send out.
Negative interest rates imply that money has no value. You literally can’t give it away. You have to pay someone to take it off your hands. Want to lend money to the German government for a few years, because you deem it a safe bet? It’ll cost you. Want to lend to the Italian government for a couple of years (I don’t know why you might, but let’s say you do)? It’ll cost you.
This rather undermines the whole concept of saving. As Fink points out, it makes the whole process of building up a pot of capital for future use far more fraught than it should be.
The actions of central banks, he says, “are severely punishing the world’s savers and creating incentives to reach for yield, pushing investors into less liquid asset classes and increased levels of risk.”
This is a major problem. If you want to secure a decent pension income when interest rates are this low, then the size of the pot you need to save goes up. However, your wages aren’t going up at a rate to match this. And meanwhile, the expected returns on your savings are falling all the time.
As Fink puts it: “For example, a 35-year-old looking to generate $48,000 per year in retirement income beginning at age 65 would need to invest $178,000 today in a 5% interest rate environment. In a 2% interest rate environment, however, that individual would need to invest $563,000 (or 3.2 times as much) to achieve the same outcome in retirement.”
So your goal is getting ever more difficult to achieve. How do you do it?
You can give up on the goal, and fall back on the mercy of the state, or the idea that “something will come up”. I suspect that’s partly the driving force behind demand for a basic income in many countries.
Or you can stick to the goal, but take more risks with your investments. Trouble is, that’s not what anyone really wants to do. This is a pot of money that you feel you absolutely need. You don’t want it at the mercy of spivvy lending schemes or uncertain investments.
So for many people, the only solution is to reduce current consumption in favour of saving even more. As Fink says: “A monetary policy intended to spark growth, then, in fact, risks reducing consumer spending.”
This is nothing new, of course. We’ve mentioned this problem many times in the past.
The question is: will central banks learn from the mistakes they’re making? I doubt it. I suspect that they are, to quote Macbeth: “in blood stepped in so far, that should I wade no more, returning were as tedious as go o’er.”
In the latest issue of MoneyWeek magazine, out today, you’ll find Edward Chancellor explaining why helicopter money is a stupid idea. And he’s right. But that hasn’t stopped central banks in the past.
Be prepared for the assault on savers to continue. My colleague Tim Price has written a lot about this in his London Investment Alert – if you don’t already subscribe, you can find out more about it here.