The Unthinkable Phenomena Will Be a New Norm – Negative Interest Rate

We all heard of such a saying: ” there is no new thing under the sun”, but the phenomena of negative interest rate, which has been started and seems to be prevalent, led by Japan, Switzerland, Germany is really challenging my intuitive thinking, so I do my research and try to figure out what’s the logic behind.

The great depression and the most recent 2008 sup-prime crisis are always referenced by economists, politician and officials in their policy decisions. During the great depression in 1929 time period, people suffered massively that horrible stories of unemployment, starvation, homeless are everywhere. And it took almost ten years for the economy to return. Whereas the Federal did intervene and bail out bunch of big companies such as AIG during 2008 crisis, they were still scolded or self-reprimanded for not doing it earlier. This explains well the Federal cuts the rate outright to zero and committed to buying out bonds even ETFs if needed, pumping up the confidence at the outset of this COVID-19 pandemic. The level of their efforts can be illustrated by their balance sheet clearly:

You can see that huge spike occurred right in the middle of March 2020, when pandemic kicked in, nation-wide shut down and stock market plummeted precipitously three times.

Two months passed now we’re still stuck in the abysmal pandemic mire. QE is still ongoing, whereas interest rate’s already been decisively cut to zero. What can the Fed do?

Looking around, the Great Britain is struggling for the same cause, Germany and Japan are better off in controlling but have to face the same pressure of fatigued economy, so these two countries have already done the unthinkable – cross the zero line to go for negative interest rate. It set a brilliant example for other countries especially for the US.

However, any reasonable person would be dumbfounded at knowing this policy, right? What on earth is going on? Who would be that push over to buy negative rate bonds? Even Warren Buffet expressed his strong concern on this phenomena.

Well are the heads of European Bank, Japan Bank dumb to do this unthinkable. Apparently NOT. They’ve taken into account probably the most exhaustive factors, situations and options they can think of and roll out this unprecedented monetary policy.

Take a look at the outcome, so far, there are about $2 trillion bonds successfully issued/purchased. So as investors, why do they buy negative return bonds?

There is a very informative youtube clip explaining reasons thoroughly. In sum, there are three reasons:

1. bonds are regarded as a trading/speculating vehicle rather than being used as bond’s natural or original function – get maximized interest return for the money you loan out. Therefore, buyers don’t really care if inters rate is negative or positive. For them it’s a pure math equation, number can go right side of zero, certainly it can go to the left side. That’s why back in 16th century, Dutch people created tulip bubble, whereas at present, Chinese people living within the Real Estate bubble without any concern. Crazy investors don’t care how much the real value underneath this tulip, or shabby apartment, or negative return bond, what they care, is that there is always another buyer willing to buy from you this “vehicle” with a higher price.

2. bonds are particularly favored as a speculative product because of it’s “convexity” trait.

From the graph above, you can see when the yield is increasing, the bond value is lower, vice versa. However, the magnitude of this change is much larger on the left side than right, meaning, if you predict the rate is going to be go smaller, the profit space is ample.

3. liquidity needs. For institutions like retirement fund, insurance companies, they may have no other resorts except taking in bonds, even when return is negative. Dealing with a whole lump of cash is more expensive.

After reviewing this phenomena in practice, let’s also use logical deduction on theoretical aspect. At the core, this policy is encouraging people to either borrow (create new ideas, technologies, start business) or consume (so the new products services created by former ones can be sold) money. The economy will be booming if this cycle is established. Obviously, if you are a saver, or a lazy wealthy child decided to do nothing but parasiting on interest return from ancestor’s estate, are punished under such circumstance.

However, money is always pursuing more money. This is the law of nature. Nobody can defy. Since debt market is not the only channel for rich people to gain their profits, they will find other channels to grow their assets. There are stock market, commodity, real estate. These markets are about to rise significantly.

Thinking deep of this topic, I realize it’s more complicated than only analyzing lending or borrowing money on individual level. Bonds, or Bills, are more a tool used by the Fed, the counterpart central banks. I will write another blog on macro level.

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