The Capital Note

The Capital Note: Interest Rates at Four Thousand Year Lows (What Could Go Wrong?)

Sir Isaac Newton ( GeorgiosArt/Getty Images)

Welcome to the Capital Note, a newsletter about business, finance and economics. On the (abbreviated — Daniel Tenreiro is busy with other projects) menu today: Negative interest rates and other negatives, “stakeholder capitalism,” Illinois taxes, the EU’s Green New Deal, magic, math, money, and Sir Isaac Newton.

Lending to Italy at 0 percent — and other absurdities.
Italy: Debt/GDP in excess of 150 percent by year end. Check.

Italy: In and out of recession since cheating its way into a currency (the euro) to which it is clearly unsuited. Check.

The Financial Times:

Investors queued up to buy Italy’s new three-year bond on Tuesday, even though they will get nothing back until early 2024.

The sale of Rome’s first benchmark government bond with a zero coupon, meaning it offers no interest payments, is the latest sign of red-hot demand for riskier eurozone debt, as investors bet that the European Central Bank will scale up its asset-purchasing programme.

The move comes just months after a coronavirus-linked credit rating downgrade by Fitch prompted speculation that Rome was headed for “junk” territory.

The €3.75bn bond priced at a slight premium to its face value, giving it a yield of minus 0.14 per cent. The Italian treasury also sold €3.75bn of seven- and 30-year debt at record-low yields. Although Italy sells a different form of short-term debt without coupons, Tuesday’s sale is the first mainstream government bond offering investors no income…

The ECB’s support has encouraged investors to set aside concerns about Rome’s huge debt …to focus on the extra yield they can capture by buying Italian bonds rather than ultra-safe German debt….

Yields on Italian debt had already fallen below zero in the secondary market. Ten-year Italian bond yields are also trading at an all-time low of 0.63 per cent, with other riskier eurozone debt following in their wake. Greek 10-year yields hit an-all time low of 0.77 per cent on Tuesday.

Amazing as it may seem, investors are behaving rationally, given that the market in which they are operating is, essentially, rigged, propped up by the ECB for reasons that include ensuring that Italy — a euro zone member that is too big to fail (it is the currency union’s third largest economy) — can service its debt. Additionally, assuming that the COVID-19 rescue package agreed in Brussels in July gets its final approvals (it will, I reckon, with some tweaks), investors know that extra EU money will be headed in Italy’s direction from next year.

Nevertheless, the fact that zero coupon Italian debt is seen as a good deal is a sign of a deeply dysfunctional debt market, with serious implications for insurance companies, pensioners, and savers. That ultra-low rates will also encourage malinvestment of one sort or another is, I think, a given. That they will encourage lending is not.

Bloomberg, from October 1:

Financial institutions increased the amount of money parked with the ECB by 1 trillion euros in under six months to 3.08 trillion euros, according to the central bank’s latest update. It’s due in large part to the ECB’s targeted longer-term refinancing operations, known as TLTROs, that charge interest rates of as low as minus 1% to aid the economic recovery from the pandemic.

The central bank is effectively paying for the money to be lent out to households and businesses. But financial institutions can use their existing liquidity to meet the criteria needed to tap this cheap source of funding, opening the door for an arbitrage strategy with government bonds and the ECB’s deposit facility, which charges minus 0.5%.

“That gives them the opportunity to engage in all kinds of carry trades,” said Rishi Mishra, an analyst at Futures First. “Short end of the sovereign bond market should be a favorite — and even parking the funds at the ECB at minus 0.50% isn’t penalizing.”

Or look at the US (via Bloomberg, from last week):

The largest banks haven’t been this cautious with their holdings in at least 35 years.

Cash, Treasuries and other securities effectively guaranteed by the federal government now make up more than 35% of the combined balance sheets of the 25 biggest U.S. banks, according to data compiled by the Federal Reserve. That’s the biggest share in records going back to 1985, and is 5.5 percentage points higher than the five-year average.

Loans and leases now account for less than half of big banks’ books for the first time on record, spurred by what appears to be a combination of lower borrower demand and lenders tightening their standards as the coronavirus pandemic drags on. The cautious stance will fuel debate over whether giant firms are prudently guarding against a worst-case scenario or exacerbating the pain by slowing the flow of credit.

“The banks have been flooded with deposits and have nowhere to put it,” said Brian Foran, an analyst at Autonomous Research. “Healthy companies don’t want to borrow because the future is still uncertain. Struggling companies would like to borrow to stay afloat, but as a bank it’s hard lending to those sectors.”

Meanwhile, with more central banks willing to contemplate negative interest rates, the picture is not going to get any brighter for investors looking for yield.

Also from Bloomberg last week:

Bank of Canada Governor Tiff Macklem said negative interest rates remain an option, even if policy makers aren’t currently considering such a move.

“We are not actively discussing negative interest rates at this point but it’s in our toolkit and never say never,” Macklem said Thursday via videoconference, after a speech to the Global Risk Institute.

The comments show the central bank remains open to the possibility of further rate cuts, even though Macklem and other Bank of Canada officials in recent months have sought to downplay the benefits of moving rates into negative territory, as some other countries have done. The Bank of Canada’s current policy rate is at a record-low 0.25%…

And, from The Wall Street Journal today:

The Bank of England asked British lenders to assess their readiness for subzero interest rates, a sign that officials are weighing the merits of a policy that bankers say would heap problems on a sector already weighed down by Covid-19 and Brexit.

In a letter to bank chiefs, the BOE said it is seeking information on banks’ “operational readiness and challenges with potential implementation, particularly in terms of technology capabilities.” The letter said the query wasn’t a guarantee that negative interest rates would be introduced in Britain.

BOE officials had long insisted they didn’t think negative rates were appropriate for the U.K. but in recent months have softened their stance as the global economy faces a slow, fitful recovery from the pandemic and the policies implemented to contain it.

“Negative rates are not a positive for U.K. banks,” said Joseph Dickerson, a banking analyst at Jefferies, adding that they send deflationary signals to consumers and businesses…

And, from Grant’s Almost Daily:

Norway, where the benchmark policy rate currently stands (or crouches) at 25 basis points.  Norges Bank governor Øystein Olsen kept the door open for a negative interest rate policy (NIRP) in a speech last Tuesday: “The possibility of further reducing the policy rate has not been ruled out.”  A move to (or below) zero “may. . . be appropriate in periods of severe financial market turbulence and sharply rising risk premiums.”

One of Olsen’s Polish counterparts went a step further. In an essay on the Radio Maryja website, National Bank of Poland monetary policy committee member Eryk Lon argued in favor of NIRP if consumer sentiment deteriorates. The central banker noted that “such a move wouldn’t even be anything strange given current conditions.”  Indeed. The NBP’s current policy rate is 10 basis points.

The European Central Bank itself first went negative in 2013, but, as Grant’s notes, just a little acidly:

[R]esults are wanting, with eurozone headline CPI inflation advancing at an average 0.9% annual clip over the past six years, compared to 1.6% in the September 2008 to Sept. 2014 epoch.


The evident solution: More of the same.


Meanwhile (my emphasis added):

The phenomenon of nominal interest rates below zero was virtually unprecedented in the 4,000 years of financial history prior to the current cycle, according to financial historians Sidney Homer and Richard Sylla, but that was then.  As of today, $16.16 trillion in global debt is priced to yield less than nothing, up from less than $8 trillion in March and not far off from the $17.04 trillion peak in August of 2019.  In terms of sovereign debt, Austria, Germany and Switzerland are paid to borrow at maturities as long as 15, 30 and 50 years, respectively.

Those figures grow far larger when accounting for the measured rate of inflation. Strategists at J.P. Morgan wrote last week that the total stock of developed nation sovereign debt sporting a negative real yield now stands at $31 trillion.  That’s double the reading of two years ago, and equivalent to 76% of total developed nation sovereign debt, up from 57% in 2017.

What could go wrong?

— A.S.

Around the Web
“Stakeholder capitalism” — Andy Kessler is not a fan:

“It’s way past time we put an end to the era of shareholder capitalism,” Joe Biden declared in Dunmore, Pa., in July. Companies “have responsibility to their workers, their community, to their country.” This echoes last year’s virtue semaphoring by 181 CEOs, when the Business Roundtable redefined corporate purpose away from shareholders and toward “stakeholder capitalism”: a collectivist creed of workers, customers, communities, climate and country. Why does it feel like we’re about to get our pockets picked?

Illinois’ proposed progressive income tax — The Wall Street Journal is not a fan:

Illinois voters will decide next month whether to enact a progressive income tax, paving the way for a new top rate of 7.99%….The Tax Foundation ranks states by tax competitiveness, and its latest analysis is bad news for Illinois Gov. J.B. Pritzker and other progressive-tax backers. The Prairie State currently ranks 36th worst in overall tax burden because its flat individual rate of 4.95% offsets very high property and other taxes….But its proposed slate of new individual income tax rates, along with a corporate tax hike tied to the same ballot measure, would drop the state’s rank overall to 47th. That would move Illinois into Dante’s ninth ring of tax hell, ahead of only New Jersey, New York and California…

The EU’s Green New Deal — Hans-Werner Sinn is not a fan:

In her first annual “state of the union” address this month, European Commission President Ursula von der Leyen confirmed that the European Union, with its Green Deal, has committed itself to a new and pervasive form of government intervention in the economy. Apparently, the bureaucrats in Brussels think that they – and only they – know which technological pathways are best for building a sustainable future.

As such, they have devised wide-ranging plans to direct the economy accordingly. The enforcement mechanisms will include tighter regulations on carbon dioxide emissions from cars (thereby dealing a death blow to the traditional automobile industry); targeted grants; and a taxonomy for the “greenness” of private investment projects that, together with complementary actions by the European Central Bank, will effectively differentiate the interest rates at which companies in Europe can borrow in the capital market.

In adopting this approach, EU politicians are purporting to know things about the costs of avoiding CO2 emissions that they in fact do not know. But because they will be spending other people’s money rather than their own, they have no incentive to seek out potentially less expensive methods of avoiding or reducing emissions. A naive faith in the wisdom and honesty of central planners – a fatal attraction we thought we had overcome in 1989 – is rearing its ugly head in Europe once again…


Random Walk
Over at Law & Liberty, Samuel Gregg reviews Money for Nothing by Thomas Levenson.

An extract:

Starting with Newton’s breakthroughs in calculus and the study of motion between 1665 and 1667, Levenson shows how the emergence of contemporary financial markets and public finance can be traced to the application to the material world of mathematical models and quantitative methods developed in the early Enlightenment…

Newton was no stranger to the world of money. In 1696, he was appointed by King William III as Warden and then Master of the Royal Mint. Perhaps because of his long-standing interest in alchemy, Newton strove for mathematical precision in the purity of coinage throughout Britain.

Alchemy! It’s often forgotten that Newton was fascinated by alchemy and the occult. In a sense, the progress of mathematics in England in the course of a century can be indicated by the fact that John Dee, possibly the greatest mathematician in the country under Elizabeth I. was more into magic than math, whereas with Sir Isaac it was the other way round.

But I digress. Back to Gregg:

Newton wasn’t, however, the only person with a passion for scientific exactness during this period. Others sought to apply the new learning’s mathematical dimension to increasing understanding of society and the possibilities for improving it. Early members of the Royal Society like Sir William Petty even strove to enhance humans’ ability to predict and shape political outcomes. “Political Arithmetick,” as Petty called it, involved gathering and then analyzing rudimentary statistics to attain knowledge which could be weighed, counted, and measured. Government officials became interested in this empirical information because it gave them more accurate insight into the resources at their disposal and therefore enhanced capacity to estimate more precisely their ability to fight wars over extended time-periods.

Therein lay, Levenson writes, “the critical step.” The desire to anticipate the future politically and militarily raised the question of how “to put a price on it.” Identifying the future costs associated with different choices about use of available resources was as complex a question as any of those tackled by Newton. The man who rose to the occasion, Levenson argues, was the astronomer, inventor, and demographer Edmond Halley (of Halley’s Comet fame).

Halley has good claim to be the architect of the mathematics that underlie modern life insurance. For Halley did more than just identify mathematical patterns in his detailed studies of birth and mortality rates. He used these patterns as a basis, Levenson writes, for assessing “the dimension of chance, of risk in the modern sense,” which is central to calculating a human life’s monetary worth at any future moment in time.

Halley’s efforts to quantify the odds of life-expectancy and to use it to assess risk involved “asking what mathematical relationship could connect an expectation that could come true years or decades down the road thanks to a decision made in the here and now.” Ironically, it took decades for the insurance industry to wake up to the full significance of this for their everyday work. But it dawned on many merchants that the new analytical tools used to assess the price of a life over time could be applied to other goods, most notably money itself. Instead of viewing money as a fixed sum, it could also be thought about as a quantity whose value—like life—could be tracked, studied and modelled mathematically through time. And thus a new science of money was born…

— A.S.

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