A strange thought - could subzero interest rates be deleveraging?

[Graham Osborn]

I had an interesting thought about the meaning of negative rates this morning while reading about the battle between banks and mortgage holders in Spain.  Think of negative rates as like discount retailing with price controls.  Buyers and sellers can't choose the price of goods, only whether or not they participate in the market.  When prices are high, retailers are looking to sell but consumers are reticent to buy -> low volume.  As you lower the price, consumers become more and more eager to buy while retailers can boost efficiency up to a point -> volume goes up.  But at some level above zero, retailers can no longer make money relative to costs and investory risk hence their willingness to sell collapses.  At some level above zero, volume peaks and starts to decline.  When applied to banks, this analogy implies that peak credit actually resides somewhere above zero and below that you enter deleveraging.

 

There is a kinetics to this which is perhaps even more important.  If retailers could be induced to sell apples for $0.01 for a period of time but consumers were told the situation would not last, consumers would hoard apples (let's ignore the perishability factor here and think home loans etc).  But suppose after an extended period the price control authority decided to reduce prices to $0.005.  Would consumers buy even more apples?  Maybe, but since they already bought so many at $0.01 they might have limited capacity (eg storage space, desire to eat more apples, etc).  This implies that if rates have been very low for very long, lowering rates further may have a limited effect to boost volume even from the consumer standpoint.

 

This matters because credit levels are a reflexive (non static) function.  Credit tends to rise or fall rapidly.  If credit cannot rise, it might hover but should fall rapidly after not too long.

 

If correct, the theory on the valuation of risk assets relative to high-grade corporate bonds becomes bogus at current levels.  Risk assets do not rise to infinite levels, but fall off rapidly as rates continue to fall with limited demand or willingness to lend.

[Dalal.Holdings]

So from your model of how credit should vary with interest rates, you'd argue that a planned, gradual expansion of interest rates should result in credit expansion as "buyers" of credit seek to lock in temporarily low rates? Trying to think more about this model...

 

On a related note, I recently watched an interview with James Grant (of interest rate observer) where he essentially described fixing rate as no different than price controls.

[Graham Osborn]

So from your model of how credit should vary with interest rates, you'd argue that a planned, gradual expansion of interest rates should result in credit expansion as "buyers" of credit seek to lock in temporarily low rates? Trying to think more about this model...

 

On a related note, I recently watched an interview with James Grant (of interest rate observer) where he essentially described fixing rate as no different than price controls.

 

Hi DH, I think from a policy perspective - per the Fed's mandate, which I don't necessarily agree with - the most logical thing to do is gradually raise rates.  Lowering rates will not do much to expand sound credit at this point, and higher rates would strengthen legitimate (as opposed to speculative eg LC) lending institutions.  Higher rates would also stave off inflation, which despite newsflow is an avalanche waiting to happen at some point.  The Fed risks take a reactive rather than proactive approach to this issue, which could result in a rapid series of hikes later on.  Of course, the timing on any of this is impossible to guess at.

 

I'm not sure I fully understand your question, but I think an important note is that aggregate and newly issued debt are highly dependent on the path of rates and so you can't hope to achieve a given credit state just by setting interest rates at a given level.

[Brice]

So from your model of how credit should vary with interest rates, you'd argue that a planned, gradual expansion of interest rates should result in credit expansion as "buyers" of credit seek to lock in temporarily low rates? Trying to think more about this model...

 

Seems that's what happens in US residential real estate whenever increases in US mortgage rates hit the popular press.  Refi volume seems to be triggered by the fall in rates but fear of rates going up drives potential buyers to pull the purchase trigger now vs risk being priced out later.

[Graham Osborn]

So from your model of how credit should vary with interest rates, you'd argue that a planned, gradual expansion of interest rates should result in credit expansion as "buyers" of credit seek to lock in temporarily low rates? Trying to think more about this model...

 

Seems that's what happens in US residential real estate whenever increases in US mortgage rates hit the popular press.  Refi volume seems to be triggered by the fall in rates but fear of rates going up drives potential buyers to pull the purchase trigger now vs risk being priced out later.

 

That's an interesting point.  I hold the point of view that CPI (and even "unadjusted" CPI including food and energy) massively underestimates price increases across the asset spectrum.  I realize this more generalized view is not widely held but I think that QE has tended to hand more wealth to the upper-middle-class and the rich relative to those below them.  The key capacitance for increasing CPI is in that lower bracket (they are the ones buying fewer groceries and cheaper cars during a downturn).  This doesn't mean the wealth won't leak to this segment over time, but it takes time at full employment for the fiat money to equilibrate.  As a result the central banks will overdo QE as well as the monetization/ stimulation phase and be deluged in a pent-up wave of classical inflation within the next 5-10 years I speculate.  Since deflation can always be cured by printing more money over the long term, I think the deflationary fears mask the opposite - a money bubble.

 

If your assertion holds true than there may yet be borrowers who will not add to the debt pool unless rates are seen to be rising in earnest.  It is an effect I didn't think about but I doubt the Fed would be quick enough to react to save real rates, just as they were in the 70s.

 

I like to think of the Fed as like the present-day healthcare system.  Physicians are obsessed with prolonging life.  When you walk into a hospital, you observe how this ideology has been reduced to a caricature.  Countless moribund and often demented old people are kept alive by extraordinary means and undergo countless procedures with the goal of extending their lives by a few months here, a few months there.  No hospital employee would ever seriously question whether "everything should be done" because it might be malpractice to do so.  The Fed and its central bank counterparts are like those physicians, trying to bump the world's moribund developed nations along by 6 months here, 6 months there.  They don't care about the long-term outcomes any more than the physicians do because they won't be penalized for those outcomes.  Rather they are most concerned with appearing to act properly in the short-term.  The interesting thing is how often, if the course of administering a marginally life-prolonging therapy, you end up killing the patient.

[doughishere]

https://www.youtube.com/watch?v=4qY8qnh8dsQ

 

Russell Napier - Ben Graham Center Value Investing 2015

 

 

There are many financial models out there that no longer make sense. What is the cost of future pension liabilities if one discounts by negative rates? Is it infinite? What is the value of the equity of companies legally bound to meet pension fund shortfalls.

 

 

We could go on but it is a long list.

 

 

Deutsche Bundesbank

No 27/2014

How is the low-interest-rate environment affecting the solvency of German life insurers?

Anke Kablau

Matthias Weiß

 

https://www.bundesbank.de/Redaktion/EN/Downloads/Publications/Discussion_Paper_1/2014/2014_10_27_dkp_27.pdf?__blob=publicationFile

 

 

Like gravity, the interest rates has a push pull mechanic.

[Brice]

There are many financial models out there that no longer make sense. What is the cost of future pension liabilities if one discounts by negative rates? Is it infinite? What is the value of the equity of companies legally bound to meet pension fund shortfalls.

 

Not infinite, just higher than the non-discounted value.