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The Interest Rate Twilight Zone

The Interest Rate Twilight Zone
(Dollar Photo Club)

By    |   Monday, 20 June 2016 10:16 PM


These are strange times.  The rock bottom interest rates that have been around since the recession nine years ago are giving way to something for more bizarre.  Interest rates are now going beyond zero and into negative territory.  It is estimated that $10 trillion worth of global sovereign debt, mostly in Japan and Europe, is now paying negative interest.

Let’s take a minute to get our heads around what negative interest means.  When a bond pays negative interest it means you have to pay the issuer for the privilege of lending them money.  On the other side of the transaction, an issuer is only willing to take your money if they get paid to do it.

Forget about the laws of finance, this violates the principles of human nature.  The whole basis of trade and economics revolves around the idea that “if you give me this, then I’ll give you that.”

But negative interest flips that central premise upside down. 

Imagine a kid knocking on your door offering to wash your car if he can cut your lawn too.  Perhaps you offer to pay for your friends’ tickets to game but only on the condition that you also get to pay for their refreshments.  Such is the madness that Central Bankers with funny accents are offering as an antidote for slow growth. 

Why are they doing this?

Central bankers didn’t just wake up one day and decide to turn things upside down. As is often the case, this weird policy evolved over several years in a step-by-step process that began started during the financial crisis.

In order to save the US and global financial system from collapse, central bankers took unprecedented steps.  Key benchmark interest rates were lowered to near zero levels and massive bond buying programs flooded the economy with liquidity.  Collapse was averted.  Then the baton needed to be handed to the politicians to make meaningful fiscal reforms.

But central bank intervention was all the excuse most politicians needed to avoid making the hard choices necessary to reform the economy and spur growth.  The Fed had this one. 

So politicians could go about the more desirable business of telling the voters how bad they felt about their struggles.  The ones who could make their eyes water while they empathized did best.

Fiscal reforms like deregulation and tax cuts needed to be implemented in order to generate real and sustainable economic growth.  But the Fed and other central banks were left to do all the heavy lifting themselves, with insufficient tools. 

All central banks can really do is make money cheap and available.  But without a sufficient level of real economic growth and real demand for the money people still don’t want it and won’t use it.  You can dangle a raw steak in front of a dog and expect him to devour it.  But if the dog has had five steaks already and he’s stuffed, he still won’t want it.  People have too much debt already and there isn’t enough economic activity to make them want to borrow more anyway.

As the years went by central bankers in Europe and Japan found it increasingly difficult to maintain subpar growth with just low rates.  In 2014, central banks in Denmark, Sweden and Switzerland lowered key benchmark interest rates below zero.  More recently, the European Central Bank (ECB) and the Bank of Japan (BOJ) have followed suit.  Negative rates have since rippled through the debt markets and Fitch Ratings Agency now estimates that there is about $10 trillion of negative yielding government debt worldwide.

I guess the idea is that if people don’t want to use money just because it’s cheap, maybe they will if they are penalized for not spending or investing.  It’s not working so far.  From recent highs markets across the globe are floundering. Germany is down 22 percent, Japan is down 23 percent, China is down 45 percent, the United Kingdom market is down 15 percent and France is down 20 percent.

Negative rates are without historical precedent.  What will result? Perhaps markets will eventually lose confidence and the debt markets and stock market will crash.  Maybe the result will be hyperinflation down the road.  It is a very complicated global financial system and the ultimate consequences such a bizarre policy is unknown.

But I do know this.  Central banks are conducting a very dangerous experiment. It’s like widely distributing a new wonder drug that was never tested or cloning people with inadequate science. 

Things can go very wrong, beware.

Tom Hutchinson is a Wall Street veteran with extensive investing and finance experience. To read more from him, CLICK HERE NOW.

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TomHutchinson
These are strange times. The rock bottom interest rates that have been around since the recession nine years ago are giving way to something for more bizarre.
interest, rate, twilight, zone
775
2016-16-20
Monday, 20 June 2016 10:16 PM
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