Download (Login required)  Audio PDF

Is it possible for interest rates to be negative? As illogical as that may sound, it is possible. In fact, it has happened already in Japan and is currently happening in Germany. Japanese interest rates went negative in 2016 for a time and again in 2019 before climbing back positive. In Germany, interest rates went negative in 2016 and 2019, coinciding with Japan. Unlike Japan, German interest rates remain negative. What is going on? Why would any government allow that to happen? What will happen in the future?

Japan

In the mid-to-late 1990s, Japan entered a challenging economic period, which continues today. The Bank of Japan (BOJ) raised and lowered interest rates numerous times and continues to do so. When lowering interest rates did not stimulate the economy as desired, Quantitative Easing (QE) was implemented. At times, these methods have paved the way for the Japanese 10-year bond interest rate to go negative.

Germany

Germany is a member of the European Union (EU) and has the most significant and robust economy among the 27 members. There used to be 28 members, but the UK left the EU in 2020 (Brexit). The EU is further divided into the Eurozone, which consists of 19 members that have adopted the Euro as the currency.

The European Central Bank (ECB) sets monetary policy for the Eurozone. The ECB has tried implementing the same methods as Japan to stimulate economic growth but has lacked robust results.

Other countries in and around the Eurozone also have zero to negative interest rates. This includes Switzerland, Denmark, Sweden, France, and Spain.

Interest Rates in Real Life

If you borrow money, you will not only be expected to pay the money back; you will likely need to pay additional interest. That only makes sense and is part of the expense of borrowing money. This applies to a mortgage loan, car loan, or almost any extended borrowing plan.

Interest Rates in the Bond Market

For the sake of this discussion, several maturity dates will be mentioned, but for comparison and discussion purposes, the 10-year government bond and corresponding interest rate, or yield, will be used. The 10-Year government bond is typically the benchmark for any country and makes any analysis and comparisons more straightforward.

Negative Interest Rates

The idea of loaning money and, instead of receiving interest, paying interest in the form of credit seems illogical. In fact, it is, although not without precedent. Throughout history, similar situations have occurred.

To help understand this concept, it is necessary to define negative interest rates. There are two definitions:

1. Real negative interest rates: The current interest rate is compared to the current inflation rate. For example, if an interest rate is 3%, but the inflation rate is 2%, the real yield is 1% (3%-2% = 1%). This is most common but is often overlooked. In days of high inflation, a person may receive 10% from their bank, but if inflation is 12%, the real interest rate is -2% (10%-12% = -2%).
2. Nominal negative interest rates: This is the interest rate of a bond traded in the secondary market. As bond prices go up, the corresponding interest rate goes down. The interest rate can go below zero.

Bonds

Bonds are debt instruments (money is borrowed). A bond is created in the primary market. After being created, it can be sold in the secondary market and bought by another investor. Prices for bonds fluctuate daily in the secondary market as supply and demand determine the current value. In the US, the most significant secondary market is in Chicago. Each bond has a defined interest rate typically set when the bond is created in the primary market. The initial interest rate itself does not usually change. However, as bonds go up and down in value in the secondary market, the corresponding interest rate fluctuates. Theoretically, this can drop below zero.

Has this happened in the US? No, not with the nominal rate of the 10-year bond. Although, 1-month and 3-month T-Bills did briefly go negative in March 2020. Can it happen? Yes. This has not happened (yet) in the US but has happened in other countries. Will it happen in the US? Currently, no. Jerome Powell, the Fed Chair, has repeatedly stated there is no intention of letting interest rates go negative. This could change. Could the Fed lower the target rate below zero? Since it was created in 1913, the Federal Reserve, AKA the Fed, has never reduced interest rates to below zero. Other “tricks,” such as Quantitative Easing (QE), have been implemented as an alternative.

 The Purpose of Interest Rates

A country’s central bank (the Federal Reserve in the US) sets interest rates through monetary policy. If an economy is growing too fast or slow, interest rates are raised or lowered to stimulate or repress growth. The theory may seem sound, but previously, poor timing has gotten central banks into trouble. Acting too early or too late may cause more harm than good.

Why Buy US Bonds?

One of the reasons the US bond market has done well over the last few decades is because foreign investors earn higher yields in the US than in their own country. When investors, either foreign or domestic, buy bonds en masse, prices are pushed higher. This causes the attached interest rate to go lower. As this process repeats, bonds trend higher, and interest rates trend lower.

Even with interest rates very low, the yield, although historically minuscule, is higher than in other countries. If an investor compares interest rates worldwide to find the most attractive yield, the US has been and continues to be the place to go. Also, US Government Bonds are considered to be risk-free. If the US has a higher yield, in addition to safety, investors flock to the US bond market. Chinese bonds currently pay a higher interest rate than US bonds but are not seen as safe.

All of this buying of US Bonds has kept interest rates low. However, this has not been enough to stimulate growth during difficult times. More intervention has been deemed necessary, such as Quantitative Easing (QE), which increases the money supply.

Increasing the Money Supply

The COVID-19 pandemic decimated the US economy. To induce economic growth, Congress and the Fed enacted numerous programs.  Congress authorized repeated rounds of stimulus checks and pork-filled relief packages, and the Fed has lowered interest rates to zero while also implementing Quantitative Easing (QE).

When QE is implemented, massive amounts of liquidity, measured by the Money Supply, are created “out of thin air” and dispersed into the US economy. How is this money created? Contrary to popular explanations, the idea of a printing press pumping out US dollars at full-steam 24/7 is not how it works. It’s a digital process that is done on computers.

The US dollar is a fiat currency. That means that US dollars are not backed by anything other than the “full faith and credit of the US government.” This promise eventually allowed the US to abandon the Gold Standard in the early 1970s. Until 1973, US dollars were backed by gold that was set at a fixed price. Since 1973, the open market determines the value of the US Dollar. Additionally, since 1944, the US dollar has been the official world’s reserve currency. This means the value of the US Dollar has global dominance and importance.

To introduce newly created money into the markets, the Fed buys bonds. The legality and morality of doing this are often debated. Regardless, this adds more money to the economy and keeps interest rates low by buying bonds. Since the 2008 housing crisis, interest rates have stayed historically low but remain positive.

Foreign Ownership

Countries such as China and Japan have purchased vast amounts of US bonds. Many hedge funds also own a lot of US debt. Some see this as a genuine concern. The US government has to pay back this debt, including interest. What’s going to happen if it can’t? What will China and Japan do? Some believe the US may be heading to some kind of train wreck in the future. A real-time view of debt can be seen at USDebtclock.org

A Debt Bubble?

The current US debt situation may frighten some, while others see it as an opportunity. A relatively new theory, known as Modern Monetary Theory (MMT), is currently making its way into the US economy and has been for years. Simply, MMT believes that government debt does not matter. Money can be printed as needed. Some love this idea, while others believe MMT is filled with unworthy fairytales, leading to economic suicide. Regardless, it’s what America has been slowly adopting for decades. The pace of MMT has increased massively with the new administration under names such as the Green New Deal, the Great Reset, Critical Race Theory, and others.

One way or another, the current situation requires something to be done. Student loan debt, mortgage debt, and government debt, all of which fall on US taxpayers, are only three areas that must be considered with logical answers and relevant education. Other areas such as healthcare, lockdown impacts, and geopolitical events require attention, yet the US is consumed with debating “other things.”

Inflation

As new money is created and dispersed, this adds to the money that already exists, as measured by the Money Supply. Simple economics tells us that when there is plenty of something, anything, it is less precious than when there is great demand. If many new dollars are being created, what will that do to the overall value? Debates abound, with each side convinced they are correct. See chart.

An increase in the money supply can make a single US Dollar worth-less. As the value of each US Dollar drops, prices must be increased. As prices go up, the US Dollar continues to lose value. The repetition of this cycle produces inflation. Since the 1970s, the Fed’s biggest crusade has been warding off inflation. For the most part, it has done so. The methods implemented can be debated, but the desired results have effectively been achieved. Despite decades of cries that massive inflation is just around the corner, significant out-of-control inflation in the US has yet to materialize.

The Road Ahead

Some pundits say that the 1970s will look like the “good old days” compared to what will happen in the future. Others make comparisons to the Great Depression of the 1930s. Still, others happily see nothing but rainbows and sunshine. Those who are extremely optimistic or pessimistic will always exist. Investors should listen to both sides for perspective but shouldn’t necessarily heed what is concluded. Reaching independent conclusions is best.

World Currencies

Insight can also be gained by watching different currencies. Interest rates in a country are closely connected to that country’s currency. Currently, the two most dominant world currencies are the US Dollar and the Euro. The US Dollar started to gain dominance after World War I (replacing the British Pound) and became the official reserve currency at the end of World War II, under the Bretton Woods agreement. The Euro has gained popularity and respect since being introduced in 1999.

Watching the Euro

Why would a significant and influential country such as Germany allow interest rates to go negative? The goal has been for economic growth and to decrease the Euro’s value against the US Dollar. Isn’t the Euro also a fiat currency, just like the US dollar? Yes. What’s so good about it? In a world of crappy currencies, the US Dollar and the Euro are considered the least “crapiest” of all. The ECB wants to help exports be more attractive, encourage tourism, and a host of other reasons. So far, that hasn’t happened.

When the Euro first came out in 1999, it was invisible at best and considered an absolute flop at worst. However, over time, it has grown in acceptance and popularity. The Euro has started to stand the test of time and has become a reasonably solid currency, so to speak. Also, Eurozone and EU businesses and travelers have only one currency to convert. However, as in Greece, this can have unintended negative consequences.

Watching the US Dollar

An excellent way to watch the US Dollar value is by following various versions of the US Dollar Index. Each index has different calculation methodologies. The $USD Index, unlike the USD Index, is an End of Day (EOD) Index. Intraday real-time indexes, such as the DXY, USD, and others, plot the OHLC (Open, High, Low, Close), which can be helpful. Even nonparticipants in the FOREX or currency futures markets may find this helpful and possibly even interesting. The $USD measures the value of the US Dollar against a basket of other currencies. The dominant currency in the basket is the Euro.

The weekly chart of the US Dollar goes back ten years. There is a green line at 80. 2014-2015 saw an increase in the value of the $USD. It shot above 100 at the start of the pandemic but has since declined about 10%. Currently, the US Dollar Index is fighting to maintain the 90 level. If this fails, further declines in the US Dollar Index may occur.

Why have a weak US Dollar?

US companies like a weaker dollar because international businesses often use the country’s currency where business is conducted. When a currency is converted into US dollars, this can look better on the books. Also, US exports are more attractive, which can stimulate US growth. The US government may unofficially adopt a weak dollar policy stance. However, since 1995, the US has officially adopted a strong dollar policy.

The Future of The US Dollar

Critics have already declared doom in response to actions by Congress and the Fed. The cries will get even louder if the $USD drops to 80. Many pundits are already calling for “the death of the dollar.” Also, common predictions include replacing the US Dollar with the Amero, and the US will become part of “Mex-Ameri-Canada.” Maybe at some point all of that will happen, but usually, when cries of impending doom become the norm, that’s about the time when the $USD starts to recover.

The following chart shows the US Dollar Index compared to the Euro. This creates a mirror image.

Watching other currencies

Other currencies worth following include the British Pound, the Japanese Yen, and the Swiss Franc. The UK never did adopt the Euro, even as an EU member. The Japanese Yen is important since it is a major currency in Asia.  The Swiss franc should also be watched.

 Cryptocurrencies

Additionally, Bitcoin, Dogecoin, and all the different cryptocurrencies are coming into play. These currencies are not backed by gold, a government, a banking system, or, in some cases, logic. Some love that, while others see disaster. Yet another group exists that doesn’t care about cryptocurrencies but sees an opportunity to make money quickly, as they become trendy and skyrocket to levels beyond comprehension.  Many of these “uninformed, uneducated, and inexperienced speculators” can help create a bubble. A bubble may have already formed in cryptocurrencies. The excitement and possibilities created by implementing new technologies and developing a decentralized and independent currency may be causing too much exhilaration too soon. The intense speculation and popularity may need to be “reset” to wash out players who lose interest quickly when dreams go unrealized. However, cryptocurrencies look to be paving the way for an alternative form of currency in the future once the technology becomes more refined and tested while also gaining general acceptance.

Conclusion

Negative interest rates, although rare, have been allowable during times of economic slowdowns as a means of stimulating economic growth. This has occurred in Japan and continues in Germany. Interest rates in the US remain historically low yet positive. As US bonds are purchased, interest rates decline. While the world endures unprecedented times due to the Coronavirus pandemic, central banks worldwide are adjusting monetary policy to prevent economic collapse. In addition to interest rate analysis, investors should also watch world currencies, specifically the Euro and the US dollar, as the money supply increases. Inflation may require an adjustment of investment positions while taking advantage of new opportunities.