The Destructive Effects of Negative interest rates

One of the best things that ever happened to me was my mother taught me to save from a very young age. Indeed when I first started primary school we had school banking where every pupil had a small Post Office bank book and every week someone from the Post Office appeared to do school banking. We were encouraged to save our threepences (3 cents), sixpences (6 cents) and shillings (10 cents) from what ever jobs we had done for mum & dad over the past week. House jobs were normal play, no house keepers where we lived.

In those days my parents had lived through two world wars and the great depression of the 1930’s. They knew hardship and struggle. Our family was working class but in business albeit one that required hard labour. They knew what thriftiness was all about, just to get by to raise their three children as best they could and school banking was part of that era of saving for a rainy day. They had lived through a period where the rainy day lasted years and years and poverty was reality for a huge number of people.

I can still recall the pleasure that I got once I was old enough to know what was going on from seeing the amount in my deposit book build up. Even more fun was it when at the end of the year someone else added some more shillings on top of my savings, my introduction to ‘interest’.

But this is no longer the way it is, central bankers have embarked on a grand manipulation, a manipulation that destroys the centuries old paradigm that those that save and accumulate savings are rewarded with interest by depositing the savings with institutions that are able to lend it to someone else who needs additional capital to expand a business or purchase a property and who will pay interest for the privilege of using funds they don’t have. The paying of or charging of interest becomes a silent arbitor of risk: when interest is added to an investment decision by a borrower it has a governing effect on investment decision making.

But now in some countries banks are paying people to borrow whilst not rewarding the savers upon whose funds the advances are made. This is an absurdity. Central bankers have manufactured a distortion and it simply doesn’t make sense. I still can’t get my head around it, even worse try to explain it to others. Sure, I’m not an economist but I live in the real world and logically know that this financial experimentation will deliver unintended consequences and like all experiments those consequences will only become apparent after the fact. I never thought negative interest rates were even possible. It is as though central bank activity is criminally working against everyone’s interests accept their own.

Such is the desperation of central bankers to avoid a recession or even another depression that they are simply doing everything they can to rig market outcomes, simultaneously not allowing the markets to be the free regulator of risk. Indeed so many comment that free markets no longer exist. Financial derivatives appear to be the only instruments that can generate a positive return because you can bet against the market. Now central bankers, cornered by their own stupidity will watch as fundamental rules of saving, investment and return are destroyed. We need to question why they would allow this to happen and who is going to profit from this. One thing I know is that they will be safe if a major blow out occurs.

It makes ‘saving for your retirement’ a questionable activity as the return on saved capital has been stolen by bankers from those who have saved or invested and effectively disbursed to the bankers all around the world. They pay virtually nothing now on deposits but they can embark on riskier lending activity that result in distortions and bubbles, particularly in asset markets.

Bonds, a conventional financial asset that are an integral part of any diversified portfolio now yield negative returns completely destroying the historical actuarial calculations that superannuation funds rely on to pay superannuitant pensions. This too forces the funds to invest into riskier assets for return. Many super funds have calculated return in the 6-8%pa range but because the funds can barely generate yield they are now massively underfunded. Central banker manipulation of interest rates is responsible for this.

Peter Schiff of Euro Pacific capital sums negative interest rates: “Negative interest rates are a disaster. It’s not working in Japan, it’s not working in Europe, it’s not going to work here. Just because it doesn’t work doesn’t mean we’re not going to do it, because everything we do doesn’t work and we do it anyway. It shows desperation, that you’ve had all these central bankers lowering interest rates and expecting it to revive the economy. And then when they get down to zero, rather than admit that it didn’t work, because clearly if you go to zero and you still haven’t achieved your objective, maybe it doesn’t work. Instead of admitting that they were wrong, they’re now going negative.”

 It has allowed the distortion to impact global share markets and created a misallocation of capital such as acquisitions (companies taking over a competitor) and companies purchasing their own shares to (falsely) show an increase in earnings per share. In other words markets become distorted from reality bloated by cheap money that disguises underlying a competitive reality.

While US acquisition activity is through the roof it rarely adds value often muddying the earnings quality of the acquirer. With interest rates so low, companies are overpaying to grow. This poses problems for investors as it makes it more difficult to value a company that is bolted together with acquisitions.

Low interest rates have also led companies to spend money to buy back shares, often using cheap debt. Revenue growth has been anemic and the only way to grow earnings per share is by lowering the share count but those buybacks have added future trouble. Instead the balance sheet of buy-back corporates holds a whole lot more debt that may backfire if/when interest rates are allowed to rise back to ‘normal’ levels. It now appears that companies that have completed aggressive share buy backs have actually under performed since 2011. Hard to explain.

Another unintended consequence is that is that it encourages banks to go out and make as many loans as they can forcing money to be lent to risky borrowers, presumably to fight the global deflationary environment.

It’s hard to see how this will end well. We are truly in uncharted territory. The bankers are well educated, but they’re doing something that’s never been done before. No one knows exactly what’s going to happen when they try to unwind it, but it stands to reason that it won’t be pretty.

Malcolm Eves 16/04/2016

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