We are venturing further into unchartered waters. The ECB has announced that it may push short term rates further into negative territory and repurchase even more assets. A few months ago, its tone was very different however. Two factors were working against this policy involving greater intervention. Firstly, the key capital ratio prevented the ECB from owning more than 33% of a particular bond issue and secondly, the risk exists, as highlighted explicitly by the ECB itself, of the banking system subsisting for a long period in a negative interest rate environment.
These 2 issues have been simply swept aside however, with the central banks now affirming that “this is no longer a problem, we shall lower rates slightly and buy a few more assets. This is how things are”.
What are the implications of this policy which is unprecedented, non-conventional or even simply incomprehensible in our monetary and financial system, which has been built up over the past fifty years or so? Negative interest rates deeply modify the foundations of finance and the very notions of financing costs and the cost of capital.
Although Modigliani and Miller are on longer with us, it would nonetheless have been interesting to hear their point of view on this subject, as they both dedicated their Nobel prizewinning research partially to the structure of capital, notably optimising equity-debt allocation. Modern finance, and more precisely portfolio management, began during the post-war years thanks to contributions from Sharpe, Lintner, Markowitz, Fama and Ross, etc. They all theorised the idea of the existence of a positive reference interest rate, which formed the basis for calculating discounted future cash flows. In these models, the interest rate is positive as it represents a type of time value, i.e. lenders forfeit immediate consumption in order to finance borrowers and, in exchange, receive remuneration. If we also take the risk of non-payment into account, the so-called risk free rate becomes a credit rate.
This entire rationale has collapsed today however. Borrowing no longer incurs any costs, but is remunerated instead, while lending money has now become costly. Credit spreads remain positive. It is therefore the time value of money which has completely changed. The central banks are fully endorsing a preference for the present. Hoarding dormant cash is punished, while debt is rewarded. The S=I equation, which states that one party’s savings finance a counterparty’s investments, is now obsolete as the central bank ensures the financing for all parties through monetary creation. Investments are therefore no longer limited to the amount of savings available.
The central bankers would like to see economic agents liberate their Keynesian “animal spirits” and spend their income. This is the rationale behind pushing reference interest rates into negative territory. This incredible scenario would imply that the economic situation is so desperate that these measures are absolutely necessary. This is not the case however, as unemployment is at an all-time low and growth is not too far from its so-called potential rate. This is our first criticism of this policy: why intervene so heavily when the situation does not require intervention?
Our second criticism concerns the efficiency of the measures implemented. In all organisations, current wisdom requires the impact of decisions to be assessed after a given time. Was the decision fair and efficient and what are the results? If the objective of the rate cuts and quantitative easing was to drive inflation higher, then the policy has failed. If the aim was to awaken animal spirits and drive savings rates lower, the conclusions are ambivalent. Although savings rates fell from 2014 - 2017, they have risen again and are now at the same level as in 2011, on a par with 2007. On the other hand, if the goal was to ensure highly attractive funding rates for European companies, then the policy has been a success. Lastly, if the objective was to cosset European investors (creditors, shareholders and bond holders), then it has also been a success on this front.
Pursuing this policy incurs a real risk of lassitude however. This factor is clearly reflected in the ECBlending survey. Economic agents have understood that rates will remain low for a long time. There is therefore no sense of urgency to capitalise on the situation, which is no longer considered exceptional and has become the norm. This sentiment illustrates the forward guidance paradox, i.e. announcing that rates will remain low for the foreseeable future, incurs the risk of subduing animal spirits. This factor may perhaps accurately describe the current situation in the equity markets. The fall in long term rates from 2014 - 2016 (by over 100 basis points) seems to have encouraged a rerating among equities, with price-earnings ratios (PER) increasing by 1 point in the US. The latest easing phase however, with interest rates falling by over 150 basis points since the end of 2018, has not coincided with an equity rerating. On the contrary, PERs have even lost 1.5 points, whereas their initial levels were similar between the two periods.
Driving rates into negative territory was only supposed to be a temporary policy in response to an unprecedented context. By rendering the situation banal or permanent, these measures completely lose their efficiency as the notion of opportunity is wiped-out.
On the financial front, the fact that debt is no longer a liability, but an asset instead, poses a number of questions. Firstly, what are the side effects? No one knows as there have been no precedents. Not even the Japanese dared go this far. They went as low as -0.1%, introducing a tiering system to protect banks, which the ECB has not done.
In practice, this is a situation in which investors are competing to lend money to companies but paying for the opportunity to finance them. Credit risk is now remunerated only in relative terms and no longer in absolute terms. The cost of capital is no longer simply the cost of equity. Ultimately, the central banks have therefore reduced economic agents’ time value to zero. All of our models need to be reviewed, but no one knows how. It was not conceivable that nominal rates could be negative and the monetary authorities have implemented these measures in order to combat deflationary risk. How low will their deflationary angst drive rates? Although this question is difficult to answer, the ultimate risk is clearly identified, i.e. a bank run, or an exodus towards countries where interest rates are not negative. Retail clients withdrawing their cash from banks and refusing to pay charges on their savings would curb this monetary policy. However, although Swiss banks have been taxing certain deposits, they have not seen any cash withdrawals. The limit to negative interest rates may still be a long way off and perhaps we just have to accept that “this is simply how things are”.
To be continued …