If you step into the unknown, don't be surprised if it doesn't pan out as you'd hoped .....

Thursday 7th April 2016

  

If you step into the unknown, don't be surprised if it doesn't pan out as you'd hoped .....

ref :- "Splurge on negative rates is deepening the global liquidity trap",  INSIGHT by Scott Minerd , The Financial Times Markets and Investing.

Whatever they may have said at the time, nobody really knew what the consequences of negative interest rates would be. Quite frankly, they still don't but in today's FT Scott Minerd, CIO of Guggenheim, gives his take on their effects so far, why they're not working and what they might mean in the future. He makes a perfectly logical and well-reasoned case, but those of a nervous disposition should be warned  --  it's not a very optimistic one.

In essence a liquidity trap is a situation whereby low / zero interest rates fail to stimulate consumer spending and monetary policy becomes ineffective. To that now slightly outdated definition we would have to add "below zero rates", and it immediately becomes clear where Mr Minerd is headed with this.

Conditions since the imposition of negative rates have been characterised by a continued deflationary environment, slower growth and stronger currencies (think Yen and Euro). In all three areas, this of course is exactly the opposite of what was intended and what is desperately needed. The accepted wisdom regarding lower rates is (or should we now say "was") that they stimulate growth by encouraging savers to spend, and investors to put their money into higher-yielding (riskier) assets whilst at the same time reducing borrowing costs for businesses and consumers. The other highly desirable though often unstated objective is to weaken the currency, which of course also helps growth by making exports more competitive. So far at least, in the new era of below-zero rates these assumptions are plainly not working out.

This may have something to do with the decline in  the "Velocity of Money" --  the speed with which money circulates through the economy. Japan is the best example of this. Instead of being encouraged to spend, negative rates are prompting savers to withdraw and hoard cash  --  the old "money under the mattress" syndrome. Or if not, to purchase stores of value such as gold. Either way, the money is not circulating in the economy.

All the evidence suggests that this is exactly what's happening, and declines in the velocity of money increase deflationary pressures: each dollar (or yen, or euro) generates less and less economic activity, which means the authorities have to pump more and more money into the system to generate growth and combat deflation.

Deflation is of course both a symptom and cause of low growth, which is what makes it so pernicious. Falling prices mean that consumers defer purchases which just adds to the vicious circle by reducing consumption and therefore slowing growth. It also means that REAL interest rates (official rates minus inflation rate) are actually HIGHER, ironically making the currency more attractive rather than less.

So if negative rates are having the opposite effects to the ones intended, what is the alternative as far as monetary policy is concerned. Quantitative easing of course ..... but there's a limit to just how much QE can be implemented even you are unconcerned with the size of central bank balance sheets. There just won't be enough government bonds to buy, which is why the BoJ has started buying ETFs and the ECB has widened the scope of its own purchases but nevertheless it looks like QE can only do so much.

So it's back to negative rates then, and the prospect of them going even lower, The fact that the BoJ has kept rates at minus 0.1% in the face of continuing poor data, and that ECB boss Mario Draghi seem to be reluctant to keep cutting, suggested that policy makers were keen to put some kind of floor under rates. But recent official comments contradict that assessment, and if nothing else is working where else are they likely to go other than to yet lower rates. If overnight rates in Europe and Japan were to go to as low as minus 1% say, what would that do to long-term rates further down the yield curve ? Yields on German 10yr Bunds would likely be way below zero, and who knows, those on 10yr Treasuries might be approaching it. If negative headline rates were a step into the unknown, then negative long-term yields for any extended period would be a leap into the abyss, the consequences of which we cannot forecast.

There may be a way out of this: Fiscal stimulus, which so far the authorities have failed to embrace. Their reluctance to do so and to rely on negative rates as part of a monetary policy that may be close to going as far as it can go means that that Liquidity Trap is only going to get worse.

Like we often say, it's just one view. For many, negative rates will take time to do their thing so the jury is still out,  but Mr Minerd for one is unconvinced. On the evidence so far it's hard to blame him.