The Terrifying Truth About Negative Interest Rates

Pushing interest rates below zero is both an act of desperation and something that in theory should have a huge, immediate impact of the behavior of borrowers and savers. The fact that negative rates have become the new normal in big parts of the world but haven’t caused the expected behavior change should scare the hell out of everyone.

To understand why this is so, think of the rate of interest as the price of money. It’s what an individual or business has to pay to get credit with which to buy and invest. As with anything else, when the price of money is high, we tend to acquire less of it and when the price is low we acquire more. So making money not just cheap, not just free, but actually profitable to borrow, while making savings unprofitable to hold should, according to conventional Keynesian economics, create a scene in the credit markets reminiscent of those Black Friday Wal-Mart videos where fistfights break out over the last remaining Barbie Doll. Businesses in particular should be borrowing and investing like crazy, igniting an epic capital spending boom.

But that hasn’t happened. In Europe, for instance, negative rates have been in place for five years …

negative interest rates Europe

… and instead of a rip-roaring post-Great Recession recovery, the result has been the kind of anemic growth that conventional economics would predict for a tight-money environment.

Business capital spending, the engine that in theory should be propelling Europe’s economy, looks like the opposite of a boom.

Europe capital spending negative interest rates

This translates into seriously boring GDP growth:

Europe negative interest rates Europe

Why call such an uneventful situation terrifying? Because of what comes next.

Europe’s current sub-2% average growth rate is too slow to stop debt-to-GDP from rising. In other words, even with negative interest rates the Continent continues to dig itself ever-deeper into a financial hole. The same death spiral dynamic is in place in US, Japan and China.

To put the problem in more familiar terms, the world’s central banks have launched their version of tactical nukes at the problem of slow growth and soaring debt, and the dust has cleared to reveal the enemy unscathed and coming back for another go.

The next recession will begin with interest rates already at emergency levels, leaving central banks with no choice but to launch even bigger nukes. If interest rates are currently at -0.5%, then push them down to -5%. If buying up every investment-grade bond didn’t work last time around, then buy up junk bonds and equities, and maybe pay off everyone’s mortgage and student loans.

This will also fail, for reasons best explained by the unfortunately non-mainstream Austrian School of economics. The Austrians focus on a society’s balance sheet and observe that when low-quality (that is, speculative) debt exceeds certain levels, there’s nothing to be gained by encouraging more borrowing. So go ahead and cut interest rates to any crazy level you want.

The inevitable, necessary result of too much bad debt is a crash that wipes that debt out. Or a hyperinflation that destroys the currency with which desperate governments flood the market in an attempt to stave off the debt implosion.

This explains why today’s negative interest rates haven’t ignited a boom (there’s already too much bad paper circulating), and also why the next round of monetary experiments will fail even more spectacularly.

The US is seeking to constrain China’s rise

Ban on companies supplying Huawei is damaging and ill-conceived

The editorial board

However great the vulnerabilities in Huawei and the broader Chinese tech sector that they have revealed, the US steps may also ultimately fail © Reuters

Huawei is under siege. Google is restricting parts of its Android operating system to the Chinese telecoms tech giant. US chipmakers are poised to suspend supplies too. The US move to put the Chinese telecoms flagship on its so-called Entity List — requiring American companies to obtain a government licence to sell to it — is a pivotal moment for the global technology industry. It represents an opening salvo in an emerging new US-China cold war. It is also a serious miscalculation.

All countries have a right to protect national security interests — nowhere more than in 5G telecoms, nervous system of the future digital economy and the “internet of things”. The Trump administration’s moves last week, however, go far beyond what is needed to address security concerns. They also seem far more than an attempt to pressure Beijing into reaching a trade deal.

They amount to an effort to decouple the US and Chinese tech sectors, leading to a bifurcation of the global industry. This reflects a view reaching beyond the Trump White House and deep into the US security establishment that President Xi Jinping’s China is a malign actor, and that its technology is on course to outstrip America’s. Indeed, the US steps appear part of an attempt to constrain China’s rise.

Echoes of the Soviet era abound, but Soviet industry was never entwined with America’s in the way China’s is. The latest US moves seem designed to cripple or crush one of the first Chinese tech companies to become globally competitive — and one that relies on American suppliers in both mobile phones and network equipment.

Assuming the US administration sticks to its measures, despite heavy lobbying by US businesses, they will damage American and other western corporate interests. Allied capitals will resent the White House’s efforts to impose its writ.

However great the vulnerabilities in Huawei and the broader Chinese tech sector that they have revealed, the US steps may also ultimately fail. They are likely to spur a Beijing-led effort to address China’s weaknesses and develop a fully independent supply chain. A historical analogy might be China’s nuclear weapons programme: the departure of Soviet advisers in the late 1950s forced it to build its own A-bomb. The result could hasten a splintering of the internet and associated technologies to which China and Russia, which recently passed a law ensuring it can cut itself off the world wide web, have already contributed.

Indeed, while China is complaining bitterly about the US moves, Beijing must take a good share of the blame for the situation it is now in. China has blocked multiple foreign companies and websites, including Twitter, Facebook, and Google services including Gmail and YouTube. The number of European companies compelled to hand over technologies in exchange for market access in China has doubled in two years, a report showed on Monday. While western intelligence agencies disagree on the size of the security threat Huawei represents, all point to China as the biggest source of cyber attacks on security and industrial assets.

If China wishes to change its image as a malign force, it must rein in such attacks. Yet Washington’s coercive steps are misguided. The US and the west should not seek to block China’s rise but encourage it to co-operate in a rules-based system, by setting good examples themselves. Washington’s allies should be free to determine what steps they judge necessary to combat security threats from Huawei or others. The US has the right to take security steps too — but not to allow these to slide into destabilising protectionism.

Suddenly, There's Not A Lot To Like

by: The Heisenberg
- Over the past three weeks, the macro narrative has taken a decisive turn for the worst.

- The Huawei bombshell looks to have made negotiations between the US and China all but impossible in the near term and Beijing is circling the wagons.
- It wasn't clear that China's economy was out of the woods and the renewed trade tensions muddy the waters considerably.
- Meanwhile, things are going off the rails in Italy again ahead of the EU elections.
It took three business days from time the US effectively blacklisted Huawei for the Trump administration to offer a concession in the form of a temporary general license that permits some transactions with the company and its dozens of non-US affiliates.
Until August 19, Huawei is permitted to buy American goods necessary to ensure existing networks remain operational and to update software on existing Huawei devices.
The decision came on Monday evening, following what I described over on my site as a "mini-panic" across the global technology supply chain. Last week, in a post for this platform, I suggested the Huawei gamble was something of a "crossing the Rubicon" moment for markets. In that post, I flagged the SOX (SOXX), which, through Friday, was headed for its second-worst month since May of 2012. By the closing bell on Monday, semi stocks were on track for their worst month since the crisis.
You didn't have to be any kind of seer to know that some manner of intervention from the US Commerce Department was in the cards. Monday wasn't an especially bad day for global equities on the whole, but the rout in semis was disconcerting for what it telegraphed about how the market was interpreting the Huawei decision. Literally minutes before the temporary general license announcement was posted to Commerce's website, I said the following in a short little post called "When The Chips Are Down":
Presumably, the Commerce Department will be forced to adopt some kind of middle ground that ameliorates market concerns and helps cushion the blow. Otherwise, this is going to quickly erode confidence. Given that the weakness in the chip space is indicative of an actual, real-world bid to dismantle the global technology supply chain, it’s difficult to imagine how this doesn’t spill over and prompt an across-the-board rout at some point in the very near future unless the Trump administration comes forward with something definitive regarding how they plan to mitigate the fallout from last week’s decision.
If you looked out across the headlines on Tuesday evening, most financial media outlets attributed Wall Street's good day to the temporary, partial reprieve granted to Huawei. The SOX rallied more than 2% and the SPDR S&P Semiconductor ETF (XSD) bested the S&P ETF (SPY) after three consecutive days of grievous underperformance. The yellow, dashed lines in the following visual mark the day the Huawei ban was announced.
To be clear, a 90-day partial reprieve from Wilbur Ross isn't going to cut it when it comes to restoring confidence and convincing market participants that the US fully appreciates the gravity of this situation. You might think the rout in the chip space is over done, but the reality is that nobody knows where this is headed. "We would expect that many, if not most, semiconductor companies will need to lower estimates," Raymond James wrote Tuesday, in a note cited by Bloomberg for a piece aptly entitled "US Chipmakers Preparing for China Trade Fight Fear That All Will ‘Suffer’".
Beyond the ramifications for semis, investors should step back and try to appreciate the big picture. I've attempted to communicate why the Huawei story is so momentous in at least a half-dozen posts over the past four days in addition to the two linked above. This is China's crown jewel on the line. Huawei is Beijing's national champion. Although the rhetoric from Chinese state media was already pretty shrill following the Trump administration's move to more than double the tariff rate on $200 billion in Chinese goods, the tone became overtly hostile following the Huawei decision. In remarks cited by a widely-read piece in the South China Morning Post, Xi on Tuesday appeared to suggest that China is preparing for an indefinite war of attrition.
Also on Tuesday, Bloomberg said the Trump administration has "for months" held off on punishing Huawei for fear of undermining the trade talks. That might sound like an innocuous headline, but it's not. Since the arrest of Meng Wanzhou in December, US negotiators have been at pains to insist that trade talks are separate from national security concerns. Implicit in that insistence was a promise that Huawei and Meng wouldn't be used as leverage. The Bloomberg story (which cited unnamed sources) suggests the US always intended to play the Huawei ace in the event the terms of a prospective trade deal weren't deemed favorable enough for Washington.
Importantly, some of China's recent stimulus efforts have been inward-looking, seemingly designed to bolster domestic demand rather than rescue the global cycle. That could be due to worries that the monetary policy transmission channel is clogged by lackluster demand for credit, or it could just be that Beijing is taking a "China first" approach this time around when it comes to stimulus. Whatever it's attributable to, it's reasonable to assume that in an all-out trade war scenario, that tendency to focus inward will be redoubled. Consider this from Barclays:
China’s stimulus has failed to boost exports from trading partners like Korea and Taiwan implying that China’s stimulus is domestically oriented and that the improvement in fixed asset investment is driven by real estate/ infrastructure at the expense of manufacturing, thereby increasing the efficacy of the policy measures domestically and limiting the amount of pass-through of this stimulus to the rest of the world. We therefore see risks of a prolonged and soggier soft patch in the global economic recovery compared to 2016. 
When you throw in the fact that April activity and credit growth data missed estimates, you're left with somewhat vexing concerns about the outlook in an environment where the US is turning the screws as tight as they'll go.
With that in mind, remember that for the better part of a decade, China has been the engine of global growth and credit creation. That's a point that's been emphasized and reemphasized by analysts since 2015, when the yuan devaluation rattled markets and China concerns were top of mind.
"Following the Global Financial Crisis, Washington had too many problems to focus on China, plus the Chinese were the driving force behind global GDP and debt creation after 2008 in a world hungry for growth," Bank of America writes, in a note dated Monday, adding that "the European sovereign debt crises of 2011 and 2012 made Chinese economic activity an even more important pillar of the world economy."
The recovery from the crisis has been tepid, and although 2017 was characterized by synchronous global growth, "gangbusters" isn't a term you'll hear anyone use to describe the pace of economic expansion in developed economies. There will probably never be an "ideal" time to confront Beijing on trade, and it's true that fiscal stimulus in the US has given the Trump administration a growth cushion (so to speak) when it comes to pushing the envelope, but there is a certain sense in which undercutting China's economy amounts to cutting one's nose of to spite the face.
At the same time, the renewal of trade concerns is weighing heavily on emerging market equities which have now erased most of their gains for the year. Notably, recent underperformance has pushed the ratio of the iShares MSCI Emerging Markets ETF (EEM) to the S&P ETF below 2018's nadir (top pane).
Meanwhile, things are going off the rails in Italy again - perhaps you've heard. Matteo Salvini has ratcheted up his signature budget bombast ahead of the EU elections and there's rampant speculation he may attempt to capitalize on League's popularity by forcing a government shakeup.
The bickering between League and Five Star is becoming wholly untenable and it's doubtful that Salvini wants to wait too long to make a move lest the Italian economy should decelerate anew and/or Italian assets succumb to another bout of turmoil on par with what we saw last May. Amid the tension, Italian stocks are on track for their first losing month of the year (bottom pane in the visual above).
Here's a bit of color from Goldman that gives you some perspective on Italy in the context of the recent risk-off mood (this is from a note out Tuesday):
In order to assess how the deteriorating macro picture has influenced performance, we benchmarked cross-asset performance to the recent changes of our first three GS risk appetite indicator factors: global growth, monetary policy and the dollar. We found that cross-asset performances since beginning of month have been in line with their implied return, except the Banks sector which has underperformed materially. 
Note that the FTSE MIB (i.e., Italian stocks on the whole) have actually performed inline with their implied beta, which means that things could get a lot worse for Italian equities in the event decent earnings are no longer sufficient to offset concerns about the banking sector, where exposure to the sovereign is actually running near historical highs.
To be clear, monetary policymakers are on high alert and will do what they can. The RBA minutes and a speech from Philip Lowe on Tuesday telegraphed a rate cut and the market still expects Fed easing. Meaningful ECB and BoJ normalization is out of the question for the foreseeable future.
Whether central bank accommodation will be enough this time around is debatable.
In case it didn't come through in all of the above, my current view is that there's not a lot to like about the setup right now.
Take that for what it's worth.


A Tale of Two Yield Curves

By Daniel Kruger, bond market reporter

Investors and Federal Reserve officials watch the gaps between shorter- and longer-term interest rates to gauge the health of the U.S. economy. Right now, the two groups are seeing different things.

That’s because they use different measures. Fed economists tend to study the difference between the yield on the three-month Treasury bill and the yield on the benchmark 10-year Treasury note. The three-month yield this year has periodically exceeded the 10-year yield, a phenomenon known as an inverted yield curve that has preceded every recession since 1975.

Many investors, however, prefer to watch the gap between the yields on 10- and two-year notes, saying moves in two-year debt can reflect expectations for Fed policy over a longer period than just the next meeting or two. And the two-year yield has held below that of its longer-term counterpart.

The benchmark 10-year Treasury yield settled Monday at 2.416%. That was 0.193 percentage point higher than the two-year yield and 0.034 percentage point higher than the rate on three-month government bills. The three-month yield most recently exceeded the 10-year yield on May 15.

One reason for the difference: the yields on two-year Treasurys reflect growing odds that the Fed will lower interest rates during the life of the debt, some analysts said. Investors aren’t betting that’s likely within the next three months, which is why three-month yields are about a quarter of a percentage point higher.

The risks facing the economy make Treasury debt maturing in two- to five-years attractive, pulling yields lower than those on shorter-term bonds, some investors said. While few forecast an imminent recession, trade tensions have spurred fears about the prospects for growth and a potential erosion of inflationary pressures that could lead to rate cuts.

The economy grew at an annualized 3.2% in the first three months of 2019 while the jobless rate fell to an almost-50-year low of 3.6% in April. Yet three measures of inflation data for April fell short of economists' expectations, reinforcing the Fed’s recent concerns about softening price pressures.

“It’s difficult to argue that the economy is weakening,” said Donald Ellenberger, head of multisector strategies at Federated Investors. At the same time, “the Fed is desperately trying to push inflation up,” he said.

A Tail Risk The Fed Can't Solve

by: The Heisenberg
- The latest edition of one bank's closely-watched fund manager survey shows a wholly unsurprising top tail risk.

- Although the pros are worried about the right thing, and have apparently taken out portfolio hedges, the level of concern seems inadequate.

- That goes double when you consider there's no credible monetary policy response to a worsening of trade tensions.

In the latest edition of Bank of America's closely-watched Global Fund Manager survey, the number one tail risk is "trade war".
"That's no surprise given the survey was taken May 3rd-9th, but trade war concerns are well below levels seen last summer," the bank's Michael Hartnett wrote this week.
Here's the visual which illustrates Hartnett's point:
When you consider that "China slowdown" worries are in part a manifestation of the trade war, it's fair to say that global fund managers have identified the trade conflict as the top tail risk for 14 of the last 15 surveys. The latest edition tallies results from a total of 250 respondents, who together manage nearly $700 billion in AUM.
Hartnett's point about conviction in what the top tail risk is not being as high as it was last summer might seem trivial, but it's not. Note that last August, some two thirds of respondents identified "trade war" as the biggest tail risk. That figure was just 37% in May.
Since August, there have multiple escalations between the US and China, including, of course, the Trump administration's recent decision to more than double the tariff rate on $200 billion in Chinese goods, China's subsequent threat of retaliation, the specter of tariffs on all Chinese exports to the US and, on Wednesday, the de facto banning of Huawei.
To be fair, the survey period noted above doesn't capture the Huawei news and it also misses another week of losses for the yuan, but the point is, the relative sanguinity (versus last summer) looks misplaced to me.
On Friday, I spent some time writing a lengthy post for this platform outlining why some believe the Huawei news might have been the straw that broke the camel's back for the trade talks. Not everyone agrees with that assessment. The US election in 2020 raises the stakes for the Trump administration and one might well argue that the US president wouldn't risk the talks with China collapsing (or an all-out trade war) for fear of economic blowback and what a falling stock market would mean for his reelection bid. That said, I continue to believe the calculus is more complex than that.
In any event, respondents to BofA's survey believe the vaunted "Fed put" (in this case, the level at which the Fed would actually cut rates, although it's not necessary to conceive of the Fed put as manifesting itself in overt easing) is struck some ~22% below the highs.
Fed put
That's probably too extreme. That assumes the Fed put wasn't re-struck higher following the December lows (i.e., that it still corresponds to an SPX beta of roughly 10 to the short rate). I doubt that's the case. That is, the Fed put isn't 20% out of the money. "Between June and December of 2018, the S&P followed a beta = 23 trajectory," Deutsche Bank wrote in a Friday note, adding that "when the market tested the Fed's resolve and sold off almost all the way to the [previous] put strike... a subsequent dovish Fed response [led to] a recovery of stocks all the way back to current levels." Assuming the beta = 23 trajectory, the Fed put is likely around S&P 2600.
The problem with even talking about the Fed put right now is that the central bank would arguably be wading into dangerous waters by cutting rates in response to trade-related market frictions. It's true that past a certain point, stock price declines serve to tighten financial conditions, and widening credit spreads exacerbate the situation, ostensibly calling for a monetary policy response. Right now, though, Fed cuts in the context of an escalating trade war could well encourage further escalations, as competitive easing emboldens politicians on both sides of the dispute to push the envelope knowing they have monetary policy cover. Those additional escalations could eventually snowball until tit-for-tat protectionism manifests itself in rising consumer prices and lower growth. At that juncture, monetary policy is constrained on the easing side by higher inflation and on the tightening side by slowing economic activity.
Meanwhile, the credibility of a central bank which participates in a trade war will have been damaged.
There's more on the Fed put and the quandary described above here, but suffice to say there aren't many good options when it comes to a monetary policy response should trade frictions get worse.
Therefore, the better outcome would be for stock price declines to be seen by politicians as the market sending a message about the extent to which protectionism is injurious to businesses and a potential headwind to growth and economic prosperity. If that message is accepted, tensions will ease and the odds of a trade truce increase, obviating the need for the Fed to respond at all.
It's important to remember that up until the latest escalation (i.e., the doubling of the tariff rate on the $200 billion in Chinese goods that were originally taxed at 10% from September 24), the trade war hasn't really had much bite (so to speak) in terms of a quantifiable, direct economic impact. As Credit Suisse wrote last month, the "fear" of trade tensions was actually more impactful than any mechanical effect.
But that will change if the entirety of Chinese exports to the US are hit with levies and if, after a delay, the Trump administration moves forward with auto tariffs. How many commentators were sure last summer that this would all die down in relatively short order? Quite a few, if not the majority.
Well, it hasn't died down. Both the value of proposed tariffs and the value of implemented levies keeps ratcheting higher.
Value of tariffs (Goldman)
Remember, roughly 30% of S&P 500 COGS are imported. Given that and given the impossibility of overhauling globalized supply chains overnight, it is a mathematical certainty that if these tariff escalations keep coming, profits will be lower, prices will be higher, or some combination of both.
The only way that doesn't play out is if you assume a wholly unrealistic combination of higher domestic revenues (which implicitly counts on the current expansion continuing) and efficient supplier substitution. That best-case scenario which avoids margin compression and price hikes is, to my mind anyway, far-fetched in the extreme.
Meanwhile, the impact of further escalations will ricochet across the globe in classic fashion.
Here's BNP, from a note out Friday:
In the medium term, higher tariffs imply reduced competition, lower productivity and inefficient distribution of resources – i.e., a negative supply shock. In the short term, recent developments’ key impact is likely to come from a reduction in global trade and persistent uncertainty, deterring investment, encouraging precautionary savings and possibly affecting the markets through higher risk premia.
Again, this will become unavoidable at some point, and as detailed above, there won't be a Fed response that doesn't come with considerable risk.
Coming full circle to the BofA fund manager survey, consider one final excerpt that drives all of this home rather poignantly:
34% of FMS investors say they have taken out protection against a sharp fall in equity markets over the next three months, the highest level ever on an absolute and net basis (net -21% say they have taken out protection).
At least folks are well-protected.