The infatuation with negative yields

As the US sails into uncharted territory, the central bank might be the last ship keeping the economy afloat

The end of the world is nigh. Ok, not the world, but at least the Western civilization as we know it. Forgive me, but that is what I am tempted to conclude based on the panic I hear about a world with negative yields.

And to put a fine point on it, the catastrophe that is to befall us is world central banks’ fault. If it wasn’t for their misguided actions, it would all be ok.

Not a day goes by when I don’t see a chart telling me how many trillions of dollars of assets have negative yields.

That is, of course, a fact that you can’t quarrel with too much. But the commentary that comes along with it, in regard to its implications for the global economy and what the root cause is, was  getting hard to take.

However, now that the prospects of negative rates is becoming a possibility (a very small possibility in my view), things are getting out of hand.

To wit, this story on Bloomberg1 with an alarming title. Financial Vandalism. Really.

None of this is to downplay the significance of negative yields per se. Of course, negative yields are unpleasant. If you are a saver, negative yields are not a good thing. It does not allow you to meet your financial goals without taking a significant amount of risk. That can make your life uncertain and quite worrisome. If you are a partially funded pension plan, negative yields are making an already tough job even more untenable. I get all of that.

And, of course, negative yields are not normal. Paying someone to borrow money from you does not make any sense. But then again, we are not operating in a normal world.

What I don’t get is this infatuation with how the economy, under all circumstances, is supposed to provide positive returns on savings through risk free assets to make it all work.

Again, if you read the Bloomberg article, what the author is lamenting is the fact that Pension Funds are not being allowed to earn an adequate return on their assets by Central Bankers and someone ought to do something about it

The problem with this line of reasoning of course is misunderstanding how savings work in a real economy.

In an aggregate context, financial assets are really not savings. They are claims against the future growth of an economy. The only savings in an economy are the skills, plant and equipment, and infrastructure built up over time. It’s these assets that will create growth and pay off all of those “savings” that will be consumed. If the economy is not going to grow fast enough to handle whatever structural issues it may face, the value of financial assets won’t be enough to meet the corresponding liabilities of financial “savings”. So negative returns on all assets, including safe assets, cannot be ruled out. Because it hasn’t happened before, doesn’t make it unlikely.

Furthermore, to ensure that the low growth or no growth environment does not become permanent, some policy action must be taken. So, central banks in that sense are mere conduits of policy initiatives to ensure that the economy grows. And, therefore, temporarily sacrificing risk free returns to keep the economy growing is a worthwhile effort.

The goal of the central bank at the end of the day is to focus on growth and employment, and not to ensure that enough high yielding assets exist in the economy to meet some threshold of claims. In other words, returns on financial assets are going to be what they are going to be. Focusing on adequate returns on financial assets at the expense of economic is a moot point as asset returns cannot be generated without underlying economic growth.

If you frame the argument along these lines, you can see why in a low demand environment that low and even negative yields may be needed to support growth. There is nothing magically different about negative nominal yields. Nobody was crying bloody murder when the real yields were negative for an extended period of time over the past decade.

The ongoing criticism of negative rates these days, really does not hold water. First, the fractional banking system can exist just fine in a negative interest rate environment. In fact a study by the European Central Bank (ECB)2 concluded that they did not find any evidence of lower profitability “once we control for the endogeneity of the policy measures to expected macroeconomic and financial conditions”.  In other words, yes, low or negative rates may hurt bank profitability. But bank profitability would be hurt even more if the economy tanks in the absence of those negative rates. Second, worrying about the efficacy of valuation models is important, but cannot be a matter of supreme importance. Finally, there are a myriad of challenges that come about because of negative rates. But for a central banker, the prize is still generating growth in the economy, not just solving the problems of market participants. Without a growing economy, the challenges of low growth will become even more challenging.

That is not to say, there are no valid criticisms of a negative interest rate policy. The biggest and perhaps the most valid criticism of negative interest rate policy is simply that the central bankers have taken the entire onus of saving the global economy from falling into sustained low growth entirely on their shoulders, and their shoulders may not be broad enough for that challenge. As Summers et al argue in a recent essay3, at this point the global economy may be better off by the central bankers simply punting it on to the politicians and forcing their hands for some fiscal measures. This of course is true, but the real world is a much crueler and harder place. Just look at Germany. This is a country that has those fiscal tools available in spades but instead has chosen not to do anything with these tools while inflicting economic pain on the European economy. A central bank watching all that play out in real time will be forced to do something more, which is what the ECB will do in the not too distant future. So, cut the central bankers some slack. They are trying to do a very suboptimal thing but that is the only tool they have available.

Of course, negative rates are painful for everyone. But if we didn’t have negative rates in an environment with a lack of political will to something on the fiscal front, the global economies would certainly tank. And then we will be pining for the good old days of negative yields.

Footnotes

1 Source: Bloomberg.com, “Pension World Reels From ‘Financial Vandalism’ of Falling Yields,” Aug. 27, 2019
2 Source: ECB, Monetary policy and bank profitability in a lower interest rate environment, October 2017
3 Source: project-syndicate.org, “White Central Banking?,” Aug. 23, 2019

Important Information

Blog header image: Raphael Koh/Unsplash

The opinions expressed are those of the author as of September 4, 2019, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

Invesco Distributors, Inc. is the US distributor for Invesco Ltd.’s retail products and collective trust funds, and is an indirect, wholly owned subsidiary of Invesco Ltd.

Krishna Memani serves as the Vice Chairman of Investments for Invesco. In 2009, Mr. Memani joined OppenheimerFunds, which became part of Invesco in 2019. Before he joined OppenheimerFunds, he was a managing director at Deutsche Bank, heading US and European credit analysis. Earlier, he headed global credit research at Credit Suisse; was in charge of high grade and high yield portfolios at Putnam Investments; and was a credit analyst at Morgan Stanley.

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