Negative Real Interest Rates Cannot Exist. Or can they?

Imagine going into a bank to borrow some money for a new car. The banker tells you that the interest rate is -3%. You look around the room for the Candid Camera camera and Alan Funt and then ask the banker to repeat what he said. So he speaks slowly so you will understand. If you borrow $10,000 from the bank today and pay the loan off in full at the end of the year – the bank will give you $300.

You immediately get very skeptical. Usually a car loan is quoted at something more like a +10% interest rate and will require that you pay back the $10,000 plus another $1,000 in interest. As such negative interest rates are not part of your usual experience and therefore require a second look.

There are two dimensions to every credit transaction. If in the above case the borrower is getting rewarded for borrowing then the creditor is getting a penalty. So right off let’s agree that negative interest rates tend to favor or incent the borrower – but do the opposite for lenders. So if this was a rugby match the side with jerseys marked borrower would be cheering. The lender side would be weeping in their Fosters.

But before going on to that excitement, we need to make a distinction between market and real interest rates. Right now, most market interest rates are not negative though some are. However it is true that many real interest rates are negative.  

First, market interest rates. How can some market interest rates be negative? Most banks are not quoting negative market rates on loans or deposits. But bonds also offer interest rates. A bond has a rate written on it – it says that if you hold this bond on such and such a date then you will receive the coupon return. So if you buy a $100 bond (you lend $100 to the borrowing company or government) with a coupon return of 4% then you would receive $4 per year. If this bond matures in one year then you will have received $104 back for your $100 investment. That sounds pretty cool. But if you sell that bond on a day when not many people want to buy you might accept $95 for it. In that case Buck, who bought this one-year bond, paid $95 for a security that will give him $104 at year’s end. He expects to earn 9.5% on his $95 investment.  A week later Buck sells the same bond on a day when the market is crazy for bonds. Myra buys the bond for $105 that day. At the end of the year she expects to get $104 back for her $105 investment. Way to go Myra! You get a -1% return on your $105 investment.  

Why would Myra or anyone else buy a bond with a negative return? One reason is that she likes the color of the print on the bond. A more important reason is that Myra looked around and noticed that most stocks, bonds, and real estate were very risky investments. While -1% doesn’t look very good in historical terms, it might look great compared to what she might get back from an investment today in a bank in Greece.

At this moment we don’t see too many cases of negative market returns. What we see more of is negative real interest rates. On Friday the market closed with the following market rates for US Treasuries – 1-year at 0.17%; 10 year 1.45%, 30-year 2.52%.  These are very low market rates. But for all these cases the real returns are negative. Why? Because a real return states the return in terms of purchasing power over goods and services. To obtain a real rate we subtract the expected future expected inflation rate from the market interest rate. How much annual inflation do you expect in the prices of goods and services in the next year? 10 years? 30 years? We could quibble but let’s just say that it seems reasonable that over any of those time periods the prices of goods and services will rise by at least 2.52%. If so, then as of last Friday there was a very negative real rate on 1-year bonds; at least a -1% real return on 10-year treasuries; and a wash for the 30-year bonds.

What is the upshot?

·         This is a time of great global financial risk and US Treasuries are the go-to asset

·         Market and real interest rates have gone so low recently because of market forces – not because the Fed drove them down.

·         This leaves very little for Fed policy to do now. Would it really help if the Fed drove these rates even lower?

·         Meanwhile borrowers are pretty happy and creditors are not.