Wednesday, March 4, 2015

Why so down?

If you've been reading Bill Gross's last few letters, you'll know that he's been a bit grumpy of late. It's that dang new trend that has hit bond markets, negative interest rates. Gross has been using words like incredible, surreal, and inconceivable to describe their arrival.Negative nominal bond rates certainly seem odd. Just look at the chart below, which illustrates what could very well be the two lowest-yielding bonds in the world, maybe all of history: the 3.75% Swiss government maturing in July 10, 2015 and the 4% Danish government bond maturing November 15, 2015. But is the idea of a negative rates really so strange?

Gross blames negative rates on central bankers who "continue to go too far in their misguided efforts to support future economic growth," in doing so "distorting" capitalism's rules. He's not alone; plenty of people claim that without autocratic price fixers like the SNB's Tommy Jordan and the Danmarks Nationalbank's Lars Rohde, rates would rapidly to rise to a more natural level like 1% or 2%.

Not necessarily. Even an economy without meddling central banks could be characterized by negative nominal rates from time to time, or, stealing from Tony Yates; "a negative rate doesn't distort capitalism, it IS capitalism."

Let's exorcise central bankers entirely from the economy. Imagine that we live in a world where things are priced in grams of gold. People walk around with pockets full of gold dust and a set of scales to measure the appropriate pinch necessary to pay for stuff. In this world, we all have a choice between two states: 1) we can hold gold dust in our pockets or 2) we can lend the dust to someone else for a period of time in return for an IOU. (Let's assume that the borrower is risk free.)

Each state has its own advantages and disadvantages. If we hold the gold dust in our pockets, we'll have instant access to a highly-liquid medium of exchange. Unlike illiquid media of exchange, liquid media provide us with the means to rapidly re-orient ourselves come unexpected events. With gold dust on hand we can purchase the necessities that allow us to cope with sudden problems or to take advantage of lucky breaks. At the end of the day, we may never actually use our gold to purchase things, preferring to keep it horded under our mattress. Even so, it hasn't sat their idly, but has provided us with a stream of consumption over time. The discounted stream of comfort that liquidity provides represents the total expected return on gold dust-held.

If we choose the second state and lend out our gold dust, we lose access to this liquidity and thus forfeit the expected stream of comfort that gold dust provides. Because we need to be compensated for this loss, a borrower will typically pay the lender a fee, or interest. But gold dust is burdensome. It is heavy and must be arduously weighed out and stored overnight in expensive vaults. IOUs, on the other hand, are a breeze to store. By offering to take our gold dust off our hands for a year or two, a borrower agrees to unburden us of storage expenses while providing us with a feather-light IOU in return.

So on the margin, when choosing between gold dust and an IOU, we are comparing the low storage costs of the illiquid IOU against the extra liquidity of cumbersome gold dust.

What might make rates turn negative in our central bankless gold dust world? Here are two ways:

1. Rising storage costs

Say that the costs of storing and handling gold dust grow substantially. At some much higher carrying cost, rather than requiring a fee from a borrower (i.e. positive interest) a lender will willingly pay the borrower a fee (i.e. will accept a negative interest rate) for the benefit of being temporarily unburdened of their gold dust. The loss of liquidity that the loan of gold dust imposes on the lender is entirely overwhelmed by the benefits of being freed from onerous storage costs. We get a sub-zero interest rate.

2. A narrowing liquidity gap

The second way to arrive at sub-zero interest rates is to narrow the vast gap between the respective liquidity returns on gold dust and IOUs. There are a few ways to go about this. Imagine that retailers who had previously only accepted gold dust as payment begin accepting IOUs too. Simultaneously, borrowers innovate by printing their paper IOUs in round numbers, making them far easier to count than grams of dust. All of this narrows the liquidity gap by improving the liquidity of IOUs. If the liquidity of IOUs improves so much that it exceeds the liquidity of the gold dust, an IOU effectively provides a greater stream of relief-providing services than gold. When this happens, lenders will clamour to pay a fee in order to lend their gold dust, since the superior optionality that an IOU provides is valuable to them. This fee represents a sub-zero interest rate.

Another way to narrow the vast liquidity gap between gold dust and IOUs is to create so much liquidity that, on the margin, liquidity becomes like air; it has no value. Neither gold dust nor IOUs can offer a superior liquidity return if society no longer puts any price on liquidity. In this situation, the interest rate on IOUs is purely a function of storage costs. Since an IOU will typically be less costly to store than the dust, the borrower of gold will typically receive a fee from the lender, a negative interest rate, in order to cover storage costs. Paul Krugman takes this tack here to explain negative rates.

So in the end, we can get negative nominal interest rates without central bankers. How far below zero can interest rates fall in a gold dust world? At least as low as the cost of storing gold dust and the degree to which the marginal value of an IOUs liquidity exceeds that of gold dust. Obviously we don't actually use gold dust in the real world, but the same principles apply to a cash-using economy. The theory behind negative rates isn't so surreal after all, Mr. Gross.

Some links to read:

Beyond bond bubbles: Liquidity-adjusted bond valuation by JP Koning [link]
What's the Actual Lower Bound? by Evan Soltas [link]
How Negative Can Rates Go? by Paul Krugman [link]
It turns out that the US was never at the zero bound by Scott Sumner [link]
What gold's negative lease rate teaches us about the zero-lower bound by JP Koning [link]


  1. The fact that safe hassle-free real natural market rates are negative is almost a direct consequence of the laws of thermodynamics that says nothing maintains itself without work and energy. Everything decays.

    Sometimes people see negative returns as unnatural aberrations. This might be because of the fact that the 20th century was one of unprecedented technological and demographic growth which made low risk positive returns easy to find.

    Central banks pricing out investment in everything that has a real return bellow -2% and replacing it with fiat may well be cutting off a source of new capital that should be gaining in importance in a context of a large cohort of wealthy people near retirement and the global savings glut.

  2. Theoretically, nothing special about the ZLB or negative rates. All else equal. All isn't.

    What is unusual is the following combination:
    -negative and falling nominal rates
    -negative real rates
    -normal and falling risk spreads

    When Yates can explain how an undistorted market allows for all three, he can label it a "capitalist" outcome.

    1. All I feel comfortable biting off (for now at least) is the question of nominal rates.

    2. I think to address Gross's distortion concern requires something more comprehensive than the mechanism of cash storage

    3. Gross says in his latest:

      "The universe of negative yielding notes and bonds in Euroland now total almost $2 trillion. .. The possibility of negative interest rates was rarely if ever contemplated in academia prior to 2014... It was as inconceivable as the “Big Bang” with its black holes that followed billions of years later; the rules of physics or in this case the rules of money didn’t apply; it was impossible to imagine."

      Cash storage and liquidity differentials address those points directly.

    4. For "notes and bonds" seems necessary to address oppty cost (i.e. availability of competing +npv projects). This brings up pessimism question automatically as long as real rates also negative.

    5. The zlb/cash storage thesis is fine as long as oppty cost of money remains positive (i.e. deflation expectations leading to positive real rate at zlb)

  3. JP, a comment on your post (and this time after having read it ).

    You conclude that it is possible to have negative nominal interest rates without central banks. I assume that, inflation generally being positive, this would mean that it would also be possible to have (even larger) negative real interest rates without having central bankers.

    But what would this mean? It seems to me that if such a situation would occur, the creation of new IOU’s (new money) would directly come to a full stop, as the issuers of such IOU’s would make a loss on them. And that would mean, assuming that new IOU’s are still being required, i.e. by firms and households wanting to invest and spend, that these firms and household would have to bid up interest rates to a level at which IOU issuers would resume issuing IOU’s, i.e. to a level where it would be profitable for them to do so.

    And it seems to me that if such a level could not be reached due to a lack of money demand, this would most likely result (in the real world) in deflation. This would lead to an increase of the real interest rate, again (unless something is really wrong) to a level at which it would be profitable again for IOU issuers to issue new IOUs.

    In short: in a world without central banks, it would be is possible to have negative real interest rates, but it would require the efforts of a central bank to reach such a situation.


    1. "But what would this mean? It seems to me that if such a situation would occur, the creation of new IOU’s (new money) would directly come to a full stop, as the issuers of such IOU’s would make a loss on them. "

      I'm not so sure of that. Banks make money on the spread between accepting IOUs (deposits) and issuing IOUs (loans). If they make a loss by lending, they can still earn spread income by accepting deposits at even more negative rates.

  4. Without money, not only would it be possible for low risk stores of value to have negative real returns but it would probably be a regular occurance. Anyone that would have a need for savings, that is work now but get value later, would either have to stockpile stuff, build capital, or give stuff to someone in exchange for some of their future production (an IOU). Stockpiling stuff, given maintenance costs, storage costs, obsolescence costs, insurance costs etc can have very negative returns. It is also not a given that people can create new capital, new businesses, that have a guaranteed positive return, especially in a slowing economy. So for example when the demand for savings grow, if a stockpile of stuff has a return of -10% and new private business has a safe return of -5%, you might as well lend to someone with a good reputation that offers -4% (the assumption is that this person has acces to better capital creation opportunities with say -3% returns ) . There is no other way to save.

    1. I will add that if there were only private currencies, any time they would get a return above non fiat private stores of values, the currencies would become highly unstable (see bitcoin ) as people would hoard them and idle stockpiled amounts would become disconnected from the amount of stuff there is available out there to buy with it.

      When people would start to try to redeem their fiat, velocity would go up, and prices too. The reason money can't have a return above market without becoming volatile and risky is that accumulated idle money doesn't have intrinsic value and isn't tied to production. Unlike with investment, the amount of stuff people will want to buy with the money risks not being created.

      The only exception is money created and backed by a formidable government legal system. Central banks and governments can make money keep value above market by squeezing the value out of other assets when money velocity rises, basically transfering wealth from real investors and tax payers using a restrictive monetary policy. But allowing non investing fiat hoarders to keep their above market returns highly distorts the investment and labour markets, creates unemployment and destroys overall wealth (as we have seen in low inflation countries particularly europe recently).