Mario Draghi, president of the ECB announced a massive new bond-buying program last Thursday in a bid to stimulate the ailing euro zone economy. The central bank’s quantitative easing (QE) program will entail 20 billion euros per month of net asset purchases for as long as it deems necessary. The ECB also cut its main deposit rate by 10 basis points to -0.5%, a record low but in line with market expectations.
The move has sparked criticism from inside the EU and out. Hans Michelbach, spokesman for Merkel’s conservative CDUCSU bloc in the Bundestag lower house of the German parliament’s finance committee said: “The ECB is administering an even higher dose of the same medicine that didn’t work in the past.” However, Draghi is sticking to his guns as he told reporters there was “a clear majority” in favor of the package.
Regular readers of this post know that we have been very critical of world-wide central banks keeping rates too low for many years. We did have a short reprieve over the last couple years as The Fed raised rates to the current lofty 2.25% (overnight rate,) but now we are sliding back down that slippery slope toward negative yields.
Not only are negative interest rates not intuitive (ask your next door neighbor what a negative interest rate means – you will probably get a blank stare in response) but they are also dangerous. Although central bankers talk about how they are doing the right things to “stimulate the economy” there will undoubtedly be unintended consequences. Our entire financial world is built on a structure of positive interest rates. Nobel prizes have been awarded to economists that developed concepts such as the efficient frontier, the Capital Asset Pricing Model and the Black-Scholes option pricing model. But when a negative value is assumed for the risk-free rate in these types of models, fair value results shoot off toward infinity. With trillions of securities and derivatives dependent on these models, how does the financial universe deal with negative rates? We don’t think anyone knows for sure.
Another serious concern is with pensions. They use a discount interest rate to determine if they are properly funded. If one plugs in a negative interest rate as the discount rate, all pensions would technically be underfunded or insolvent. The only pensions that would be properly funded would be those with assets exceeding expected liabilities and of course, none of them are set up this way. Low interest rates are bad enough for these pensions that may be assuming a 6% return annualized. Negative rates on fixed income would of course be devastating.
And then we have the repo or repurchase market. This is the very short term lending and borrowing that entities both private and public do for near term liquidity. This is the basic plumbing of our financial system. If those rates go negative, it of course makes no sense for the owners of securities to lend. They would have to pay money for the right to have someone borrow their securities – they wouldn’t do it. Damage to the short term lending market could be a serious unintended consequence of negative interest rates.
For now, we have high interest rates as compared to the rest of the developed world. The Fed is expected to lower the discount rate in its meeting the next couple days, however, so our rates are coming back down too. Of course we hope that rates never get negative here, but we will keep that potential on the radar. In the meantime the stock market is parked just off all-time highs – which may actually be a function of expectations of low to negative rates here as there are so few investment alternatives to stocks in the fixed-income world.
Regards and good investing!