Negative Interest Rates—a Minus for Growth ?

Barron’s

Pimco’s Gross sees ultra-low rates as a deterrent to credit, contrary to theory.

Return of capital has trumped return on capital—even more than when Will Rogers originally made that observation during the Great Depression of the 1930s. So much so, in fact, that investors may get the chance to pay Uncle Sam to hold their money. That was the message of the cover story of this week’s Barron’s print edition (« Just Don’t Lose It!« ). But now this sentiment has gone a step further.

Specifically, the U.S. Treasury may issue securities at negative interest rates. Some Treasury bills have been bid up in the secondary market so their prices result in a negative yield if held to maturity. As a result, the government securities dealers that advise the Treasury on its borrowings, a massive operation if there ever was one, suggested letting Treasury bills to be auctioned at negative yields as well.

While government securities have traded in the secondary market at yields below 0% previously, both in the U.S. and in Germany, it is still an alien concept I’m trying to comprehend. It may not compare with quantum mechanics where sub-atomic particles behave differently than in the familiar world of Newtonian physics; but the notion of an investment with a negative guaranteed return is something hard to get my head around.

And I’m not referring to Treasury Inflation Protected Securities, some of which have traded at negative real yields for some time. That doesn’t take into consideration the inflation compensation in the form of payments based on the consumer price index. (Hoi polloi can get a relative bargain with I-savings bonds, which are savings bonds that receive the CPI adjustment, but with no negative yield. But I-bonds are limited to annual purchases of $5,000 a year per person.)

As in the sub-atomic world, interest rates of zero or below can have unexpected effects. Bill Gross, Pimco’s co-chief investment officer and Barron’s Roundtable member, observes in his February missive that interest rates pinned at or near zero can have unexpected effects. In particular, he observes, « Money can become less liquid and frozen by ‘price’ in addition to the classic liquidity trap explained by ‘risk.' »

The theory behind pushing down short-term rates is that it will force investors and lenders to look for other, riskier opportunities to earn a return. The liquidity trap refers to the « pushing on a string » syndrome, where borrowers are unwilling to borrow, even for virtually nothing, and the money just sits there.

But Gross perceives a new aspect to this state first observed in the Great Depression. In the absence of loan demand, banks always had been able to take the cheap money from the Fed and buy short-term Treasuries. No longer.

« What incentive does a bank have to buy two-year Treasuries at 20 basis points [0.20%] when they can park overnight reserves at the Fed at 25? What incentives do investment managers or even individual investors have to take price risk with a five-, 10- and 30-year Treasury when there are multiples of downside price risk compared to appreciation? At 75 basis points, a five-year Treasury can only rationally appreciate by two more points, but theoretically can go down by an unlimited amount. »

Given that risk-reward tradeoff, no wonder investors would rather sit on cash instead of extending credit, Gross concludes. Or even accepting the loss of a few basis points to have the safety or liquidity of T-bills. Cash also has « optionality, » according to Mohammed El-Erian, Pimco’s co-CIO, which means it offers upside when investment opportunities come along, with no downside.

But even as the Fed’s vow to maintain low rates all the way until late 2014 puts a floor under the Treasury market, « zero-bound money may kill as opposed to create credit, » Gross concludes. « Developed economies where these low yields reside may suffer accordingly. It may as well induce inflationary distortions that give a rise to commodities and gold as store of value alternatives when there is little value left in paper. »

Gold continues to move higher—up another $9.80 Thursday to $1759.30 an ounce for the active April Comex futures contract, an 11-week high—but so have other forms of paper. Specifically, Microsoft (MSFT) traded briefly over 30 Thursday, something the stock has done only briefly since the overall market’s high of October 2007, and about half of its dot-com bubble peak. Microsoft also yields 2.68%, some 86 basis points more than the benchmark 10-year Treasury.

For the economy, near-zero or negative interest rates are not the unalloyed positive that the Fed or economics textbooks portray them to be. But for investors, there are alternatives to cash yielding less than nothing.

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