Negative Interest Rates: Consequences and Concerns

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The news is startling; the implications are intriguing, perhaps scary. Interest rates on certain European government bonds are now negative, meaning that purchasers are paying those governments to hold investors’ money. European companies are exploring the possibility of issuing zero interest rate bonds. One – GDF Suez SA, a French utility – did so, selling €500 million in bonds that pay no interest over the two years until maturity. Berkshire Hathaway Inc. is planning on raising over $3 billion by issuing zero-rate Euro-dominated bonds. The proceeds would be used to pay down dollar-denominated debt or to fund acquisitions.

Are European governments, GDF Suez or even Berkshire Hathaway truly risk-free investments, warranting zero interest rates? Of course not. Lending to any one of those entities entails some degree of risk. Normally, debt buyers would require some amount of interest payment to warrant taking the risk. So, why are investors willing to do so? It seems to me that two factors are at work.

First, the glut of cash in the financial systems – Europe, Japan, the U.S. – has driven up demand for all financial assets, including bonds. As demand goes up, so do prices. We are in a (debt) sellers’ market; too much money is chasing too few offerings, driving up prices. And when debt prices go up, their yields go down.

Second, investors are not purchasing these bonds because they want or expect to earn no interest. Rather they are buying them because they expect the prices to go higher. In other words, they are willing to pay a high price today because they figure that at some point in the future someone will purchase the debt from them at an even higher price. And of course that buyer is assuming that at some point another buyer will come along and pay even more. And on and on…

The implications of this phenomenon include a need to rethink how we view the debt markets. Bonds are no longer viewed as long-term investments providing fixed returns. Instead, they now look an awful lot like equity, with investors expecting (and needing) appreciation in value. In addition, the expectation of, and need for, appreciation – particularly when tied to a not irrational expectation of further central bank intervention – could lead to a bubble in the bond markets. If in fact a bubble develops, or already exists, then its popping will cause a drop in prices, an increase in interest rates and a drag on economic growth.

The scary part is that we have seen this all before. From tulips in Amsterdam to ranch homes in Las Vegas, the hope or expectation that someone will pay more justifies crazy prices – until it doesn’t.  test

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