When interest rates go up, and they will, the 50% increase across the board will topple markets, namely bond markets.
Today’s interest rates are unprecedented. The lowest possible bound for an interest rate USED to be 0%. In finance terms, we call it the ZLB or the zero lower bound. Today bond yields in Germany and Denmark (among others) are NEGATIVE! What does this mean for me, the common investor?
Examples of Interest Rates in History, for relativity:
I’ll admit, I’m not finished with the 700+ page novel written by Sidney Homer first published in 1963. The preface is packed with insightful information such as:
1.) In ancient India, the going rate of interest on livestock was 100%. Then: You can borrow my cow for one year, if after the year is over you’ll pay be back with two cows. Today: I’ll let you use my house for a year, but after that, I’m gunna need that house back, plus a whole extra house.
2.) In early 20th century Indo-China, loans on rice were given at a rate of 50% annually commonly.
3.) In British Columbia, a phenomenon called “potlatch” was first documented. The Kwakiutl, an Candaian Indian tribe, used thin white blankets currency, roughly valued at $0.50 per item. The citizens of this tribe would give the blankets as ‘forced loans’ to one another, with the expectation of receiving what they gave plus interest. “Wealthy Indians vied with each other to see who could give away the most blankets, all with the understanding that even more would be given back—usually double.” – (p. 23, Homer) Kind of wonky huh? They gave because they were greedy.
4.) In Northern Siberia, domesticated reindeer, horses, and sheep were used to collateralize loans. They exchanged the animals like currency, usually charged at an annual rate of 100%.
All in all, lending is not new, but this new environment of negative interest rates is new. You have never had to PAY someone so they can use your money, that just seems backwards. Remember quantitative easing (QE*)? The Europeans are doing the exact same thing. However, the European Central Bank (ECB) are buying up these negative interest charging bonds because the ECB is attempting to inject liquidity into markets. The ECB is allowing banks to use their cash and they’re paying the banks interest… hmm…
The goal of QE* is to inject liquidity into markets to avoid disastrous outcomes. The program is designed to allow debt to be more readily available for the average consumer. Lowering interest rates and loading up commercial banks with cash will help settle investors’ concerns surrounding a global financial meltdown without a doubt. This being said, if times are bad (economically), the average consumer will become risk averse, and will stay as far from debt as possible until things get better. When consumers get a pay raise or a new job, they might think about taking out a loan to build a new deck or get a new car. Demand drives supply and the policy makers who control interest rates and QE can only control supply. No matter how hard they try to get us to take out debt, we just won’t do it unless market conditions are appropriate. The final result of QE in the United States was a massive increase in the amount of cash that banks hold in reserves.
The graph below shows the level of reserves banks have on their balance sheet from 1984 to 2008. In 1999, banks jacked up their reserves because of Y2K scares; if the whole system imploded at the turn of the century, they wanted to have enough cash on hand to prevent a catastrophic collapse of our financial system. Notice how the level was just shy of $70 billion.
This graph below shows what has happened to reserves since the beginning of quantitative easing. In 1999, (from above) the level of reserves his $70 billion, here $70 billion isn’t even on the scale. This is where all the bailout money went, onto the balance sheets of big banks.
Holding reserves used to be an implicit tax for banks, because the more cash they held, the more return they were missing out on (opportunity cost, for you econ buffs). The banks could have put the currency to work in stocks or bonds to achieve a higher return. However, the less cash a bank has on hand, the more risky the institution is. The Fed instituted a return on cash of 50 basis points (0.5%) in order to incentivize holding cash reserves (both required* and excess). The banks can hold all of it in cash and make a half a percent annually or they can buy negative yielding bonds. It’s a positive, riskless yield. Why wouldn’t banks take advantage?
*Note: by law, the required reserve ratio in the US is 10% for big banks.
QE works as a mechanism to prevent economic collapse, but demand drives supply; thus, you cannot force people to buy things they don’t want (except maybe in Communist Russia where they don’t actually tell you what you’re taking until you’re disqualified for the Olympics) QE cannot create prosperity because no matter how available you make debt, it is the preferences of the consumers that ultimately drives demand for loanable funds.
The Federal Reserve of the United States holds way, way more power than Donald Trump and Hilary Clinton, yet when they make a statement in the press, it usually doesn’t even make the front page. The Fed has the power to control interest rates. They also have the power to create money, as in printing currency (yup, money growing on trees). They control what you pay on your mortgage and they control how much interest your money makes (in markets and in savings accounts). This affects how soon you will be able to retire, how much your house is worth, how much your pension has in cash (i.e. how much risk your pension can take), how much your kid’s college fund will make… you name it, the Fed controls it. The best part is, you didn’t get to elect these officials. The US government deemed it too risky to put big financial decisions in the hands of under-informed citizens (*cough* Brexit *cough*).
Thanks for reading.
Note: For more on pensions taking on too much risk check out this economist article, http://tinyurl.com/hg4rbjl
Side note on bond prices –
Bond prices are inversely related to bond yields. That is, when the rate on a bond rises, it’s price will drop. Because today’s rates are so low, the effect that a rise in interest rates will have will be massive. For a little relativity, interest rates (the fed funds rate) in 1999 was around 5%. A 50% increase in this rate would raise the rate to 7.5%, which is a massive jump. Now, we are debating a 25 basis point* increase in rates, which brings them from 25-50 bps to 50-75 bps. This may seem trivial, but that represents the same 50% increase in the fed funds rate!
*Note: a basis point is a ten thousandth of a percent; 1 basis point = 0.01%