Negative Interest rates: Impossible, Irrational or Just Unusual

hi there welcome back today I'd like to talk about a phenomenon that is in the news and it does make me uncomfortable it's a phenomena negative interest rates that you're seeing in multiple currencies the Japanese yen the Euro is getting there the Swedish Krona and the Danish kroner the Swiss franc and I'll tell you upfront that I'm not a macroeconomist I'm not that well-versed in monetary economics what I don't know about central bank's could for several books but that said I have to make sense of negative interest rates before I start doing my corporate finance and valuation questions so this is more for me than for you and I'd like to talk through what I think is going on in markets so let's start off by looking at the facts it is true that we've had stories about some currencies having negative interest rate so most of these stories relate to central bank's changing their rates are setting them below zero so the first thing I'd like to show you is what central bank rates look like as of today and if you look at that table you can see there are two currencies with negative interest rates one one is Switzerland the other Sweden and two currencies with zero interest rates Japan and the European Central Bank Denmark is slightly above zero but you can see a lot of central bank rates are either close to zero or below zero now that by itself is neither here nor there because central banks can set rates those rates apply to a very small subset of borrowers early banks borrowing from the central bank so in the case of the Fed in the u.s. they set the Fed Funds rate which is not an interest rate that you or I could ever see it's a rate at which banks borrow at the Fed window but that's the starting point central bank rates have no negative in some currencies and that is uncommon unusual perhaps even unprecedented but what's more interesting our market interest rates because the Fed doesn't set market interest rates and in some currencies market interest rates have done negative at least on short-term basis the German euro bond rate on it on its short-term bonds and the Japanese short-term bond rate are both negative but there's also long-term bond rate which is the market rate set for long-term bonds and there you can actually see the contrast between the euro and the Japanese yen the euro has positive long-term rate so it's it's a very small positive number the Japanese long-term rate is actually negative now you might wonder why make this contrast between central bank set rates short-term rates and long-term rates you can actually explain away central bank rates by saying hey you know what central banks control that process they can do whatever they want it's much more difficult to explain market rates than central bank rates turning negative and it's much more difficult explain long-term market rates turning negative than short-term rates because short-term rates have done negative before in fact in October in November of 2008 during the crisis the table rate went negative and you could argue that because of crisis investors will fly to the Fed flight towards safety can make rates like negative so what makes things interesting and perhaps difficult to explain are that long-term rates in some currencies have done negative in fact to lay out the table of what long-term rates look like I looked at government bond rates note that these are not always risk-free rates because in some of these government's there is default risk so you'd have to subtract out that default spread to get there but if you look at these government bond rates you can already see that this was Frank and the Japanese yeah and are in fact in negative territory so that's what setting off this angst among analysts what do we do now what would a negative interest rates even mean as I said I'm not an economist or an expert in monetary economics but when in doubt I always go back to basics and I go back to my basics and then thinking about what it is that drives an interest let me call this an intrinsic interest rate when I lend money to you there are three things I've got to keep in mind the first is by lending money to you I'm giving up current consumption for future consumption and you'll have to pay me something for that so the preference for current consumption is the first component that becomes what what get what gets called the real interest rate second if I lend money to you and there's inflation the currency it would be a rationale of me not to cover that inflation the second component is expected inflation now if you're a risky borrower there'd be a third component which would be a default spread I would charge you because I'm uncertain that you'll pay me back but let's assume you're a default free borrower the government and the government in this case is let's say default free the risk-free rate in the long term should then have two components in a real interest rate and expected inflation and what's going to drive this the more I prefer current consumption the higher the real interest rate will become in an economy and the higher intrinsic rate shipping so in an in a fundamental one intrinsic well that's what she's going to interest rates but like everything else interest rates are set by demand and supply so there's a second way of thinking about interest rates which is to think about the supply of bonds and the demand of bonds and the interest rate is coming up is the intersection between those two so if holding all else constant the demand for bonds increases you should expect to see interest rates go the the price of the bond go up in interest rates go down if the demand decreases you should expect to see the price drop off and interest rates go up so you could actually argue that the market process of demand and supply sets interest rates now what connects the two well you remember the people who demand bonds in the bond market presumably our investors were thinking about real interest rates and inflation so there is a feedback loop here which connects intrinsic markets to that demand and supply view of interest rates now if markets were fair and efficient the two numbers should be the same but like any other market the bond market can sometimes do strange things and the interest rates set by demand and supply can deviate can deviate from the intrinsic interest rate for how long is not quite clear but they can deviate why can't they deviate first you can get deviations because investors are being irrational irrational or what sense they expect to have no five percent inflation rate but they lend money are at 3 percent because they're playing games in the market they're hoping to sell to somebody else at a different price it could be because during a crisis there is this sudden surge of demand or supply coming into bonds in fact that's how I view the flight to safety that happens during a crisis that pushes down interest rates and pushes up bond prices but there's a third factor that I've kind of left our name which is the giant in the room or the elephant in the room with the central banks and I know lots of people view central banks is this is incredibly powerful entities that can make the market interest rate whatever it should be now don't agree with it but let's look at the mechanisms that central banks have at their control to affect rates one of the mechanisms of course is that bank borrowing rate that I showed you the rate at which they lend to other banks the Fed Funds rate in the case of Central Bank and that's even though it affects only a very small subset of borrowers that sends signals to the market about what the central bank thinks about the economy let me back up and explain when the central bank lowers the Fed Funds rate when the Fed lowers the Fed Funds rate it is telling you if it's a credible if it's a credible central bank that it sees weakness in the economy and very low inflation so there are signals that emanate from the central bank when they set rates which means that those signals travel into the market so lowering of rates by the central bank to just its banking customers can cause lower rates at least in the short term and perhaps even pull down long term rates so the effect there is a signaling effect central banks can also take a much more direct role in the bond market and that's in fact what quantitative easing allowed central banks to do the Fed came into the bond market and it bought bonds what does this do it increases the demand for bonds because it adds to the existing bond buyers now how much a central banking mark or market operation can affect rates will depend on how big the central banking action is relative to the total market now remember the US Treasury market is a huge market Nieman if the central bank is buying eighty ninety one hundred billion dollars bought with the bonds it is a relatively small slice but it could could affect rates so central banks have those two mechanisms and through those two mechanisms they hope to effect interest rates now why don't they want to do that well there's a very simple reason and will come and we'll come back and talk talk about it but let's think about given these two perspectives whether we can end up with negative interest rates in an intrinsic world in other words if interest rates are set with real interest rates and expected inflation going into them can interest rates become negative well the answer is yes with the caveat if you have very low or no growth in the real economy in other words real interest rates have gone too zero and as deflation in a currency I guess you could have negative interest rates now what's the caveat well when interest rates turn negative and I'm talking about nominal interest rates and you're a person with money to save rather than put in a bank and lose one percent or two percent of that money which is what a negative interest rate would do you could keep it as cash right so the historic argument against nominal interest rates rates starting negative is that people will then hold cash well if cash were costless to hold and transact with that would be absolutely true nominal interest rates could not drop below zero and in Switzerland in Sweden and Denmark in Japan people should be taking the money out of banks and stuffing it under the mattress the proverbial stuffed cash under the mattress but there is a cost to both holding cash and transacting with cash and that causes increased relative to what it used to be 20 years ago 50 years ago the first is you got to stuff that cash under a mattress right so first you give a million dollars in cash or a hundred million or two hundred million can you imagine how big your mattress has to be and how high off the ground it's got to be before you stuff that cash let's say you could after you stuff the cash you know what you have to worry about that everybody knows you got cash stuffed under your mattress and it's going to try to break into your house you got to pay for security so in other words holding cash is not costless it's not like putting your money in your back pocket and I can forget about it because if you have enough money this is going to cost you probably not that much but there is a cost there's a second issue which is now we usually need cash to do transactions we you write cheques we use credit cards we're not used to using cash anymore in fact there are lots of transactions where you probably could not use cash if I bought a house for a million and a half and I decided to pay with cash the first thing that'll probably happen is somebody would call in the FBI saying this guy's paying with cash he must be a drug dealer the other is how the heck am I going to lug a million and a half in cash to pay for a house so I think we're paying the price for moving increasingly to a cashless economy is banks can lower rates below zero and was still leaving our money with banks because we need the convenience of being able to write checks and use our credit cards so there's a cost to holding cash interest rates can turn egg but there is a lower bound if interest rates become - 2 - 3 - 4 % my guess is that the cost of holding cash is not going to prevent you from keeping the cash so there is a point at which you're going to see people pulling money out of banks so now let's think about why central bank's even want to drive interest rates if you think about how interest rates play out in the financial asset market those interest rates especially if they're the risk-free rates become the base from which I build my required return on stock so when I go out and buy stocks I start with a risk-free rate and add an equity risk premium to it so the risk-free rate becomes the base on which I build the equity risk premium that's my required return on stocks and in conjunction of the cash flows and stocks you drive stock prices in the corporate bond market I start with the same risk-free rate I had a default spread for the bonds depending on how much default risk I see and that becomes my cost of debt which if I discount coupons back at that cost of debt given it gives me a corporate bond prices so holding all its constant a lowered risk rates you can see that both the required returns and stocks and bonds will go down and when they go down I'll be willing to pay higher prices for both stocks and bonds that is the connection between the risk-free rate and financial assets how about the real economy the same risk-free rate goes into a composite risk premium that businesses build in we call this a hurdle rate a cost to capital this becomes the rate of return businesses need to make to invest in real assets land building equipment machinery R&D whatever that real investment is so holding all its constant when you ever risk-free rate that's lower you have a lower hurdle rate right if you have a lower hurdle rate and your returns and investments have not been affected you're able to invest more so real investment increases and when real investment increases as consequences for real growth which goes up and potentially for inflation as well so that's how interest rates feed into the real economy now let's get back to what banks hope will happen when they lower rates they actually and I call this a hubristic central banker central bank Oh thinks he's the only smart guy in the room that everybody just does his bidding or her bidding when they lower it so in this world central bankers actually think they said in straights they using whatever little control they have they're able to set interest rates so here's how it works the central banker lowers interest rates long-term rates not just short-term rates low as long-term rates because of lower is free rates the cost of equity in the cost of debt both go down stock prices and bond prices go up so you get a stock market and a bond market boom because the hurdle rate for companies go down they get more real investment going so there's more real growth and there's a side benefit when you lower rates as a central bank you can weaken your currency say that's how awful not from the perspective of real growth because a weaker currency means that your export is in your country now have an advantage with the export so maybe there'd be more export-driven growth so in a humoristic bankers world they think that they can lower that Fed Funds rate or central banking rates and through that have all these transmissions that translate in all this great stuff for both financial asset markets and for the real economy unfortunately the real world is not that cooperative in the real world here's what happens the banker doesn't set long-term rates he said whatever small rate he has under his control or her control so in Janet Yellen and the Federal Open Market Committee changed the Fed Funds rate nothing's changed in the bond market yet either the short term of the long term and depending on how much credibility the central bank has there may be a transmission we talked about this into the bond market into short term rates and long term rates so that becomes a maybe you don't even control market interest rates assume that you are able to move interest rates in the direction you want them to go market rates so let's say you're able to push down long term rates the rest of the story is not under your control either the very fact that you acted you as a central bank acted is going to send signals to both the equity in the bond market what kinds of signals probably bad signals about how how much growth there is in the economy what you see in the economy investors reassess the price of risk what does that mean equity risk premiums and born to fall spreads don't stay fixed they change and often they change in the opposite direction in other words when risk-free rates go down risk premiums go up that risk premium Schiff could actually be large enough that it offsets the drop in the risk rear end you could end up with lower stock prices and lower bond prices after a Fed after the central bank cuts rates you think what about exchange rates well you went out there and cut rates saying if I cut my interest rates or reduce my interest rates my currency will get weaker but what if other central banks are doing exactly what you're doing in other words as this as the danish central bank lowers rates what if the ECB also lowers rates this becomes a race to the bottom in other words everybody ends up with lower rates and exchange rates might not shift in fact exchange rates might move perversely after you cut rates they might actually your currency could actually get stronger now in terms of the real economy here is a potential problem that risk free rate feeds into your cost of capital but because you've affected the price of risk there's no guarantee that your cost of capital is going to be lower even though you might have lower descri rates and there's an even more potent problem that expected return from real investments on projects assets whatever you're investing in that doesn't stay constant so when you see the central bank acting you as a company reassess those numbers so you see the central bank lowering rates you're saying hey that must mean the economy is not doing that well I'm going to lower the returns I think I can make on projects so the real investment you thought would happen doesn't also happen so put differently the central bank goes out there and lowers rates thinking all this good stuff is going to happen nothing happens in fact bad stuff starts happening I read a new story that the Japanese central bankers were surprised at how the market reacted to their lowering rates below zero what's the surprise the surprise comes about only because you thought you controlled all the levers when in fact you controlled none of them in fact let me give you some evidence on how I think risk premiums have changed as risk-free rates of change as many of you know I compute the implied equity risk premium for the S&P 500 at the start of every month this is basically an expected return on stocks based on stock prices and cash flows so I'm going to show you what those numbers have looked like over the last 15 years and I'm going to show you the risk-free rate nature here's what the graph looks like take a look at the food the each of the columns see if you look at the full columns each of these columns is a the expected return if you look since 2008 the expected return on stocks has been surprisingly stable around 8% you think so what the risk-free rate has dropped from about 4% down to less than 2% in other words even as the risk-free rate is drifted down you see that expected returns and stocks haven't gone down risk premiums have gone up to compensate now bond default spreads haven't been as you know as have been increased as much as equity risk prints but last year you saw bond default spirits also go up so that's at least evidence that risk premiums don't stay constant as central bank's tried to play with interest rates so in terms of dealing with negative interest rates here's what I tend to do in corporate finance and valuation and there are three choices you have and you can decide what you want to do the first is if I give you Nestle to value you might say look I don't want to value in Swiss francs because the interest rate is negative you have an easy alternative valued and British pounds are US dollars a different currency which has positive rates that's a bit of a cop-out you can run and you cut you cannot hide from this but that's the first choices switch to different cards you just make sure you stay consistent in doing everything in that currency nodes if I decide to value Nestle in US dollars my cash flows have to be in US dollars as well when I do my discount rate in dollars the second and potentially dangerous game that some analysts have been playing and this is even before negative rates is to normalize risk-free rates what does that mean replace today's risk-free rate with what you think is a normal rate the only problem is normal is in the eyes of the beholder I tell people you tell me you know what your normal risk-free rate is I'll tell you how old you are and what I mean by that is we tell me normal tea bond rate is five-and-a-half to six percent you're probably too old to be doing finance to begin with probably near 70s if you say it's about four and a half to five percent you're probably in your 50s if you say it's about four and a half percent you're probably in your 40s if you say it's two and a half to three percent you probably started working five years ago so there's no guaranteed normal that we all agree on so you so that's the first problem the second is a risk-free rate is what you tell me you will invest in if you don't buy the stock or this investment you're looking at and if you've normalized that risk reated and told me a normal keyboard rate is 4% and i reject a stock because it's overvalued and i said where's this 4 percent investment we'd invest in you better find me a 4 percent investment so normalization is dangerous but it's a game that you can play if you're willing to normalize everything so if you decide to use an intrinsic interest rate instead of the actual interest rate in other words inflation and real interest rates you get to then make sure when you do your cash flows that you using those numbers to get your growth rates and inflation rates the third and this is my preferred choices even if you give me a negative risk-free rate I will leave it negative it's not like my cost of equity is going to be negative in Swiss francs so when I value Nestle in Swiss francs I would start with a negative number let's say it's minus a half a percent the risk premium mature market premium right now is about 6% and that's pretty much global that'll give me a cost of equity but even if I view Nestle as an average risk stock a cost of equity of five and a half percent you think that's a really low number you're right it's a really low number and here's the other shoe waiting to drop if I decide to work with that negative risk-free rate then I've got to bring that same frame of reference into my cash flows what am I talking about remember I said negative risk rates are consistent with a low growth perhaps a zero growth economy with deflation when I do my cash flows I've got to bring in that low growth and deflation into my cash flows which means my growth rates are going to be much lower and in perpetuity which is where they mattered the most I'm gonna actually set your growth rate to a negative number I'm in fact when assume that if you're a mature company and I'm doing evaluation in Swiss francs your growth rate in perpetuity is minus a half a percent of your forever you're saying that's so unfair but remember you get the benefit of the interest rate being low I have to cap the growth rate to keep you from kind of having an inconsistent set of assumptions about the economy in your valuation so what's the bottom line I don't like negative rates I think they make me they don't just make me uncomfortable they just seem unnatural I've learned to deal with them but to me they can never be good news I cannot visualize a healthy economy that's growing with negative interest rates so the very fact that interest it's a negative is bad news not good news second when I see central banks embarking on these negative interest rate missions they look to me like kamikaze I know missions where central banks are first acting a little insane because they've been doing this for six years doing what lowering rates and lowering rates saying hey this is gonna work this is gonna work it hasn't worked for six years lowering rates and hoping that'll push it you know make the economy grow faster so why is it going to work now and to me the very fact that they keep going back to this lever even though it's not working as a sign of an you know if impotence that they have lost all power which is kind of scary because as an investor you want Sun you want at least preserve the illusion that central banks have some power and to me this is a sign that they don't the tide is I think there are going to be consequences from negative rates for six years we've pushed people who need fixed income further and further into the weeds what I mean by that is if you're in his 70s and you need to invest your money someplace where you need a fixed income each period we're making it more and more difficult for those people to find investments to take in a negative interest rate world so what is it gonna mean they're going to be victims of scams of all kinds I mean all I need to do is offer somebody at 3% guaranteed return and they're going to come flocking to me so as a Bernie Madoff I don't need an eight percent return in this market to get a scam going all I need is a three percent return I also think that when you see phenomenon like Yukos where you take a company new break it out into a big dividend part and the rest part of the demand for that is coming from the fact that interest rates have become so low that investors have to go wherever they need to go and they're going to date more and more dangerous places seeking that fixed income and finally I wrote about Bitcoin a few years ago and I've thought about it for a while and I Bitcoin is it's has its prompts it's a there's a paranoid fringe that runs the Bitcoin mechanism that means that might never make that jump into being an established currency but I think the more central banks in regular currencies keep playing these stupid games and these are stupid games of lowering rates to zero and below the greater the opening they offer to a digital currency that actually meets the requirements for a good currency in other words has an issuing authority that you trust in the stage I trust a really powerful computer over a central bank any day and I think that you I think that opening is now greater than it's been historically so let's see whether that changes things but in in summary I I would not lose any sleep of a negative interest rates I don't lose sleep over any financial and use to begin with but especially overnight over negative rates they're not a sign of central banking strength it's not a central banking conspiracy if anything it's a signal of how weak central banks have become I hope you found this session useful thank you very much for listening

Channel: Aswath Damodaran

Views: 27,819

Rating: 4.9620852 out of 5

Keywords: Corporate, Finance

Id: l2uFBD2v8BI

Length: 25min 9sec (1509 seconds)

Published: Fri Mar 11 2016

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[u/ripvanap]

This guy knows his shit.