How negative interest rates increase volatility and lower future returns. What can you do about it.
In this episode you’ll learn:
- Why risk management is critical for investing.
- How much of the world’s population is living under negative interest rates.
- How negative interest rates negatively impact consumers, pension plans, insurance companies and banks.
- Why negative interest rates increase the risk of investing.
- How falling interest rates move future investment returns into the present.
- What to do to protect yourself against rising interest rates.
Why Negative Interest Rates Don’t Work
I recently visited Victor, Idaho to eat dinner. Victor is a small town with approximately 2,000 residents located on the Idaho side of the Teton Pass from Jackson Hole, Wyoming.
As I pulled up to park near the restaurant I was annoyed once again by Victor’s unconventional parking law. The city requires reverse angle parking in which cars are required to back diagonally into the street level parking spots.
This is easier than parallel parking as it requires fewer maneuvers since the parking stalls are at an angle. I should be happy about this as the only car accident I ever had where I was at fault was in college when I managed to get a rusty side panel on our family’s 77 Dodge Aspen hung up on another student’s car while parallel parking.
But when you are hungry and used to quickly pulling head first into the nearest angled parking stall, the added steps required for reverse angle parking can be annoying.
While we waited for our dinner, I began searching the internet for studies that proved reverse angle parking was safer than parking head first. There were several references to traffic engineering studies indicating reverse angle parking was safer, but I couldn’t locate any them.
Then I stopped looking because I realized common sense dictates reverse angle parking is indeed safer.
The safest parking method is the one where your eyes have the best view of potential hazards that could lead to an accident. When pulling out of a reverse angle parking spot my eyes have an optimal view of cars and bicycles moving along the street. When backing into a reverse angle spot the main hazard is running over the curb or backing into stationary cars next to the parking spot.
Making sure we have the clearest vantage point when danger is high and there is a lot of motion just makes sense. This is an example of risk management.
Jeffery Gundlach who heads the investment firm DoubleLine Capital recently said in an interview on Real Vision TV that in investing “risk management is everything.”
Gundlach is one of the best performing bond managers in the world and he admits they are only right 70% of the time. 30% of the time they are wrong and underperform their target benchmark. Risk management is what allows them to minimize the damage when they are wrong.
As we discussed last week, the vast majority of professional investment managers trail their target benchmark, suggesting they are right 50% or less of the time.
As individual investors, risk management suggests most of our publicly traded investments should be allocated to index funds and ETFs.
Victor, Idaho’s unconventional parking policy has been controversial with several public hearings from upset citizens and business owners demanding the city revert to a more conventional approach.
Despite its controversy, Victor’s parking experiment is limited in scope. The town is small and even if the policy is a complete failure, the unintended consequences will be localized to a small municipality who got its first traffic light less than two years ago.
The same cannot be said for the unconventional policy of negative interest rates implemented by several of the world’s central banks.
Standard & Poor’s in a recent study estimates 500 million people in the Eurozone, Scandinavia and Japan are living under negative central bank interest rates, a policy move S&P calls a “clear sign of desperation.”
What Are Negative Interest Rates?
Former Federal Reserve Chairman Ben Bernanke describes negative interest rates as follows:
“In practice this means that, instead of receiving interest on the reserves [banks] hold with the central bank, banks are charged a fee on reserves above a threshold. The expectation is that, to avoid the fee, banks will shift to other short-term assets, which drives down the yields on those assets as well, possibly to negative levels. Ultimately, the efforts of banks and other investors to avoid negative returns on the shortest-term assets should lead to declines in a broad range of longer-term interest rates, such as mortgage rates and the yields on corporate bonds.”
The theory is lower interest rates will encourage more spending and borrowing, boosting economic growth. Secondarily, as interest rates fall, investors in theory will shift into other asset classes, hoping for higher returns. The resulting asset boom will make us all feel wealthier, encouraging us to spend even more.
The first part of the theory has worked incredibly well. As central banks have implemented negative short-term rates, longer-term interest rates have also declined. Switzerland, Japan, Germany, Austria, France and Sweden have negative nominal interest rates extending out seven years or more. Over a quarter of the world’s government debt now yields below zero.
The Downside of Negative Interest Rates
Where the theory falls woefully short is it doesn’t encourage more consumption, boosting economic growth. Instead, it encourages more saving.
Consumers looking at meager returns on their fixed income investments realize they need to save a significantly higher percentage of their income in order to prepare for retirement and other future expenses such as college for their children.
Likewise, pension funds and insurance companies also face significantly lower returns, potentially forcing them to cut benefit payments. Or the fear of them doing so, will prod households to save even more.
Negative interest rates also threaten the banking system, as accounting profits get squeezed as loan rates decline but banks as of yet are unwilling to charge borrowers for safekeeping deposits at banks.
One reason central banks have implemented negative interest rates is they are worried about deflation, but as DoubleLine’s Jeffrey Gundlach points out negative interest rates are “definitionally deflationary when you are taking $100 and turning it to $98 dollars over the course of 5 years” with interest rates yielding -0.4% on five year bonds.
It is interesting that Federal Reserve Chair Janet Yellen in her recent speech at the annual Jackson Hole economic symposium titled, “The Federal Reserve’s Monetary Policy Toolkit: Past, Present, and Future” did not mention negative interest rates as one of the potential tools the central bank could employ.
Perhaps, the Fed as it looks at the result of negative interest rates around world realizes this unconventional policy doesn’t work.