Negative Real Interest Rates Show Yield Trade in Bubble Territory

By: EconMatters

No Financial Crisis

This is one of my main criticisms of central bank policy, especially the last three years when there was no financial crisis but all the central banks continued to keep interest rates at recession era levels which has incentivized inappropriate uses of capital allocation, and this money being used for yield arbitrage plays would be more beneficial to sustainable growth projects and overall growth in the economy if interest rates were normalized.

ECB Rates Too Low – Deflationary Capital Allocation Incentives

We see the pernicious aspects of below normal interest rates; the lower they go the more inappropriate and actually deflationary aspects in some cases of how investment capital is allocated. Take for example, the recent ECB measure to lower their equivalent Fed Funds Rate from 25 to 15 basis points, what did this incentivize? It incentivized a bunch of capital to run into European Bonds which were already at recent historical lows and chase more yield plays, so much so that the German short term debt up to two years has even gone negative on real rates.

When you have investors flocking to investment choices all in an effort to take advantage of ridiculously low borrowing costs, really 15 basis points, more time and energy is spent on paper or in this case electronic arbitrage capital allocation strategies, that could better be spent in other areas of the European economy which actually promoted business development projects with real returns, and not more electronic arbitrage plays where all the capital stays locked up in financial markets and does no good for the economy at large, it creates no jobs in Europe!

Japan is Prime Example of the Curse of a Low-Rate Strategy

We see it in Japan, low rates for a prolonged period of time are deflationary in a sense because they encourage the wrong types of investment choices, strictly financial yield and carry trades instead of alternative and more productive capital allocation in terms of small business loans and business development projects.

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Normalized Rated Get Rid of Many Non-Productive Capital Allocation Strategies

Normalized rates lead to real lending because the banks realize that they can no longer do these stupid yield arbitrage finance ‘gimmickry’ plays and must find real means of making money, i.e., make loans to businesses and produce real growth in the economy.

Corporations Need Real Growth When Stock Buybacks are no Longer an Option

Furthermore, corporations also play a role in this because they no longer think gee I can borrow so cheaply let me borrow at these absurdly low rates and buy back stock, low rates for psychological reasons, and I mean rates at such abnormally low levels, actually affect the psychology regarding how capital is used by corporations. It shouldn`t make a difference but it sure does, a healthy interest rate almost mandates a healthy investment return and a productive use of capital by corporations.

You sure don`t see corporations borrowing and loading up on debt to buy back stock when interest rates are higher! It is almost as if low rates incentive having little respect for the value of money, where with normalized rates respect for capital and the value of money is increased. I sure notice this correlation effect, when a corporation doesn`t think about buying back stock to make their EPS number look better, then they have to look for alternative ways to make their stock attractive to investors and make their numbers. This leads to more focus on growing the business, so then borrowing goes to organic growth and business development projects that add real economic might in the form of ‘additive effects’ to the economy.

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Central Banks can Promote the right kind of Capital Investments

This is how central banks can incentivize the right kinds of behavior by corporations and investors which add real sustainable growth to the economy by raising interest rates, and thereby raising the importance and value of capital. This leads to real capital allocation strategies instead of what we have today which negative real rates are illustrating via the incessant and over-reaching for yield in all areas at the expense of more productive uses of this same capital.

Zero-Bounding Rates is not the Answer for Real Growth

The ECB needs to learn the lessons of Japan that actually raising interest rates instead of lowering interest rates once you cross the 50 basis point threshold is actually simulative for growth by better incentivizing the right kind of capital investment in the region to more productive means. The proof is in the pudding: How long was the ECB rate at 25 basis points, how long under 100 basis points? And what was the growth in the EU over this time?

Basically nonexistent, once you cross and stay below the 50 basis point threshold, a central bank is actually doing more harm to their economy than good, maybe at first blush it seems paradoxical in nature, but if you examine some of the negative side effects of zero-bounding rates for an extended period of time it starts to make sense.

Once a certain interest rate threshold is reached, ‘zero-bounding’ rates for an extended period actually stunts economic growth and central banks need to come to grip with this monetary reality! Anytime there are negative or even close to negative real rates for bonds that is a sign that central banks need to change policy, they are in a sense reinforcing the very thing they are trying to avoid, they incentivize an over-reaching for yield at the cost of real growth, and this is deflationary, as it lowers the value of money.

By EconMatters

http://www.econmatters.com/

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