WSJ(8/9) Interesting Situation: When Rates Turn Negative
(From THE WALL STREET JOURNAL)
By David Wessel
It has been five years since the onset of the global financial crisis. The first cracks in financial markets appeared in August 2007. That is so long ago, it's easy to overlook just how unusual these times are.
Here's one signpost: Investors are so skittish that instead of demanding interest when they lend to governments, they are actually paying to put money into the coffers of the financially sturdiest governments. We have blown past zero interest rates. Investors lend 100 euros (or Danish kroner or Swiss francs) and get back 99 and change.
The European Financial Stability Facility, backed by the stronger governments of Europe, this week borrowed 1.43 billion euros ($1.77 billion) for three months at a yield of minus 0.0217%. Denmark recently raised 420 million kroner ($70 million) at minus 0.59%. Even more remarkable, Germany borrowed 4.17 billion euros for two years at an average yield of minus 0.06%. Markets have pushed two-year yields on Swiss government debt below zero regularly, and Belgium, Finland and the Netherlands occasionally.
Interest rates below zero used to be more economists' fantasy than reality. Few thought central banks would ever need, let alone be able, to cut rates below zero. When the U.S. was struggling in 2009, Harvard University's Greg Mankiw observed that minus 3% rates would help. "You could borrow and spend $100 and repay $97 next year," he wrote. That would give spending a boost. The problem, he added, is "nobody would lend on those terms. . . . It would be better to stick the cash in your mattress."
Then Mr. Mankiw joked that the Fed could say that one year hence it would pick a digit between zero and nine and cancel all currency with a serial number ending in that digit. "Suddenly, the expected return to holding currency would become negative 10%," he wrote. "People would be delighted to lend money at negative 3% since losing 3% is better than losing 10%." He wasn't serious. (Though some readers thought so.) His point was to illuminate the difficulties central banks have when they take short-term interest rates to zero -- and still can't get the economy moving. Which is pretty much where we are today.
(One alternative is more inflation. The sticker price on money remains at zero, but rates adjusted for inflation go negative, giving people a reason to borrow and spend. But that's for another column.) So why would anybody put their money in a security that is guaranteed to pay less than they put in?
One, they are scared. With so much anxiety about the ability of some governments to pay their debts and the viability of some banks, investors are paying for safety. In Europe, if they hold euros, they want to be sure they get euros back; they are avoiding countries that might abandon the common currency.
Two, new rules on banks are stepping up demand for government securities, deemed safer and more liquid than alternative investments.
Three, central banks are pushing already-low benchmark rates lower. Denmark is charging banks a fee for parking money at the central bank; it wants to keep its rate below the European Central Bank's to keep its currency from rising against the euro. The ECB last month cut the rate it pays banks on overnight deposits to zero. The next obvious step is to charge a fee. ("On the negative deposit rates, I will say only that for us these are largely unchartered waters," ECB President Mario Draghi said the other day.)
The Federal Reserve is still paying 0.25% on bank reserves, but cutting that rate is on its things-to-think-about list.
The notion is that cutting that rate would give banks an incentive to lend more and store less money at the Fed. The U.S. Treasury, meanwhile, is pondering tweaks to its debt auctions so that it could borrow at negative rates as Germany does.
Negative rates are just the latest wrinkle in today's low-interest-rate world. "The average person on the street is beginning to feel the collateral damage," says Mohamed El-Erian of bond giant Pimco. "Not getting paid much on your money-market fund, or, if you're European, not being able to access money-market funds. Underfunded pension funds. Less attractive life-insurance products. The bet that's being made by central banks is that the overall benefits of very low or negative yields compensate by keeping the economy going."
Several European money-market mutual funds have stopped taking new money: They can't invest it at a rate high enough to cover their costs. Few banks are actually charging to take deposits, but a move by the Fed to push down the interest it pays on reserves could prompt that. Last year, Bank of New York Mellon drew headlines when it told large clients it would charge them a fee for deposits; the bank couldn't invest the big sums profitably.
Negative rates on overnight or other short-term money are difficult enough. When rates on two-year and longer-term debt securities go negative and stay there, then banks and insurance companies start to run into trouble. They make much of their money by borrowing at short-term rates and lending at higher long-term rates or, effectively, guaranteeing higher rates to their customers. That doesn't work so well when yields on two- or three-year securities are negative. The global financial crisis is five years old. It isn't over yet.
Copyright (c) 2012 Dow Jones & Company, Inc.