Many Americans believe interest rates cannot go negative in the U.S., even though government debt in many other nations is already paying a negative yield. It is not an easy concept to grasp since it makes little sense why an investor would lend money to the government knowing they will receive less back when the bond matures. Interest rates are most likely headed negative during the next recession when you understand how it is possible.
Understanding the bond market is not as straight forward as the equity market. There are multiple factors that can affect Treasury bond yields and for different reasons, such as the amount of debt being issued, the demand for new loans and asset prices. The primary driver of interest rates is the monetary system.
In a debt-based monetary system, such as ours, economic expansions are inflationary as evident by an expanding currency supply. Treasury yields expand to soak up the additional supply of currency entering the system. When the economy contracts, debts are written down and defaulted on, which causes the currency supply to decelerate or worse, contract. When there is a large amount of debt chasing a small amount of currency, interest rates fall.
With a record amount of debt in our economy, during the next recession, all the debt will be chasing a smaller amount of currency. Logically one might assume with a small amount of currency chasing a large amount of debt, that interest rates should rise. All government debt be purchased, which crowds out the private wealth generators in the economy who are forced into buying government debt.
From a lending perspective, interest rates are a function of supply and demand. When there are more borrowers than money to lend, interest rates rise. When borrowers vanish and banks still need to lend to generate a profit, interest rates fall. Recessions are a function of slowing or shrinking consumer demand, which is why interest rates will fall during the next recession just like they have in all prior recessions.
In a bizarre way, currency manipulation tools such as Quantitative Easing, lead to lower and even negative interest rates. It is quite evident that excessive currency printing in Europe and Japan has led to negative interest rates, and for the same reasons, when the Federal Reserve is forced to ease during the next recession, interest rates will go negative.
The intended consequence of Quantitative Easing is to raise asset prices to incite lending demand. American’s have a high propensity to borrow against appreciated assets, and in a debt-based monetary system, the economy expands as the debt expands. The problem with inflating asset prices is that those who do not own assets must pay an above-average price to buy. When asset prices become out of reach for new entrants, interest rates fall.
The housing market is a perfect example of how interest rates could become negative. To revive the economy during the next recession, the Fed lowers interest rates into negative territory through Quantitative Easing. The influx of currency from QE into the economy causes asset prices to rise. New home buyers cannot afford the higher home prices, so the banks offer a negative-yielding mortgage.
The concept of a negative-yielding mortgage or loan may sound farfetched, but we are likely to see negative-yielding loans in the future if the Fed can extend the depth of their monetary experiment. Assuming a bank is borrowing from the Federal Reserve at a negative rate, the bank would pay the borrower a slightly less negative rate to borrow. The bank could generate a positive return on the loan from the spread between the negative yield offered by the Fed and the negative yield offered to the buyer.
While it may be possible for banks to survive on negative interest rates, the notion of negative interest rates will not be positive for depositors or the overall health of the banking industry’s balance sheet. Adding to the perplexity of negative rates is the relationship between the dollar amount of Mortgage-Backed Securities held by commercial banks and thirty-year Treasury yields.
Starting in January 2015, the Federal Reserve began reporting the dollar amount of Mortgage-Backed Securities held by commercial banks. Oddly enough, thirty-year Treasury yields are nearly perfectly inverted against the dollar amount of mortgage bonds held by the large commercial banks. While the financial services industry seems shocked that thirty-year Treasury yields are trading at an all-time low, the dollar amount of MBS held by commercial banks is nearing its all-time high.
In last week’s update, I surmised the relationship between the bank held amount of MBSs and Treasury yields had to do with the low-credit quality of loans being sold off the Federal Reserve’s balance sheet back to the banks. After all, these were the poor performing loans from the Great Financial Crisis that the banks bundled into MBSs and sold to unsuspecting investors. Now that the banks are getting these bad loans back, they want to increase the amount of high-credit quality of loans on their balance sheet by lowering interest rates.
Regardless of the actual reason the relationship between thirty-year Treasury yields and the dollar amount of Mortgage-Backed Securities held by large commercial banks exists, it does. From an investment perspective, knowing the Fed is planning to sell $20 billion worth of Mortgage-Backed Securities from its balance sheet every month, means thirty-year Treasury yields are going to stay low and head even lower.
The problem with thirty-year Treasury yields being low is they are lower than the upper bound of the Federal Funds Rate, or bank overnight lending rate, and are threating to trade lower than the lower bound of the Federal Funds Rate. While the Fed and former Chairman of the Fed publicly state that the inversion of long-term Treasury yields against the Federal Funds Rate is not a big deal, it is.
Large commercial banks borrow money from the Federal Reserve to lend it out at a higher interest rate. When the borrowing cost for the large banks exceeds its potential revenue from lending, then banks curtail lending. Financial conditions tighten when banks increase the lending criteria required by borrowers, which limits the number of borrowers who can qualify for a loan.
To fix the imbalance between the Federal Funds Rate and prevailing interest rates, which was caused by the Fed raising the Federal Funds Rate and unwinding their balance sheet, the Fed is then forced into easing financial conditions. Easing financial conditions involves lowering the Federal Funds Rate, as they have already started to, and potentially resuming Quantitative Easing. To fully ease financial conditions, history shows the Fed will have to lower rates by five-and-a-half percent from its prior floor.
During the next easing cycle, which the Fed states has not begun, the Federal Funds Rate will have to fall below minus seven percent, since its prior floor during the Great Financial Crisis was minus two percent. When the Fed eases, Treasury yields across the curve fall along with the Federal Funds Rate. In past easing cycles, Treasury yields typically fall two percent from their prior floor.
It seems strange that future generations may never know what positive interest rates are, as the Fed will likely continue their grand experiment of trying to create a perpetual economic expansion by inflating asset prices and lowering interest rates into negative territory. While it may be possible for the banking system to survive with negative interest rates, under a negative interest rate regime, the government will likely be forced into nationalizing the banking system.
In the meantime, for those who believe we are closer to the next recession, investing in Treasury bonds will offer the potential for high returns, without much risk. Knowing the large commercial banks are being forced to buy the Fed’s unwanted Mortgage-Backed Securities, means the commercial banks are putting downward pressure on yields. With the probabilities of the Fed being forced to lower the Federal Funds Rate to ease financial conditions, it makes owning Treasury bonds the place to be in the months to come.
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