Wednesday, March 4, 2015

Why so down?


If you've been reading Bill Gross's last few letters, you'll know that he's been a bit grumpy of late. It's that dang new trend that has hit bond markets, negative interest rates. Gross has been using words like incredible, surreal, and inconceivable to describe cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365ir arrival.Negative nominal bond rates certainly seem odd. Just look at cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 chart below, which illustrates what could very well be cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 two lowest-yielding bonds in cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 world, maybe all of history: cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 3.75% Swiss government maturing in July 10, 2015 and cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 4% Danish government bond maturing November 15, 2015. But is cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 idea of a negative rates really so strange?

Gross blames negative rates on central bankers who "continue to go too far in cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365ir misguided efforts to support future economic growth," in doing so "distorting" capitalism's rules. He's not alone; plenty of people claim that without autocratic price fixers like cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 SNB's Tommy Jordan and cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 Danmarks Nationalbank's Lars Rohde, rates would rapidly to rise to a more natural level like 1% or 2%.


Not necessarily. Even an economy without meddling central banks could be characterized by negative nominal rates from time to time, or, stealing from Tony Yates; "a negative rate doesn't distort capitalism, it IS capitalism."

Let's exorcise central bankers entirely from cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 economy. Imagine that we live in a world where things are priced in grams of gold. People walk around with pockets full of gold dust and a set of scales to measure cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 appropriate pinch necessary to pay for stuff. In this world, we all have a choice between two states: 1) we can hold gold dust in our pockets or 2) we can lend cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 dust to someone else for a period of time in return for an IOU. (Let's assume that cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 borrower is risk free.)

Each state has its own advantages and disadvantages. If we hold cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 gold dust in our pockets, we'll have instant access to a highly-liquid medium of exchange. Unlike illiquid media of exchange, liquid media provide us with cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 means to rapidly re-orient ourselves come unexpected events. With gold dust on hand we can purchase cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 necessities that allow us to cope with sudden problems or to take advantage of lucky breaks. At cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 end of cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 day, we may never actually use our gold to purchase things, preferring to keep it horded under our mattress. Even so, it hasn't sat cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365ir idly, but has provided us with a stream of consumption over time. The discounted stream of comfort that liquidity provides represents cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 total expected return on gold dust-held.

If we choose cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 second state and lend out our gold dust, we lose access to this liquidity and thus forfeit cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 expected stream of comfort that gold dust provides. Because we need to be compensated for this loss, a borrower will typically pay cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 lender a fee, or interest. But gold dust is burdensome. It is heavy and must be arduously weighed out and stored overnight in expensive vaults. IOUs, on cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 ocá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365r hand, are a breeze to store. By offering to take our gold dust off our hands for a year or two, a borrower agrees to unburden us of storage expenses while providing us with a feacá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365r-light IOU in return.

So on cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 margin, when choosing between gold dust and an IOU, we are comparing cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 low storage costs of cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 illiquid IOU against cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 extra liquidity of cumbersome gold dust.

What might make rates turn negative in our central bankless gold dust world? Here are two ways:

1. Rising storage costs

Say that cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 costs of storing and handling gold dust grow substantially. At some much higher carrying cost, racá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365r than requiring a fee from a borrower (i.e. positive interest) a lender will willingly pay cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 borrower a fee (i.e. will accept a negative interest rate) for cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 benefit of being temporarily unburdened of cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365ir gold dust. The loss of liquidity that cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 loan of gold dust imposes on cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 lender is entirely overwhelmed by cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 benefits of being freed from onerous storage costs. We get a sub-zero interest rate.

2. A narrowing liquidity gap

The second way to arrive at sub-zero interest rates is to narrow cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 vast gap between cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 respective liquidity returns on gold dust and IOUs. There are a few ways to go about this. Imagine that retailers who had previously only accepted gold dust as payment begin accepting IOUs too. Simultaneously, borrowers innovate by printing cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365ir paper IOUs in round numbers, making cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365m far easier to count than grams of dust. All of this narrows cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 liquidity gap by improving cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 liquidity of IOUs. If cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 liquidity of IOUs improves so much that it exceeds cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 liquidity of cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 gold dust, an IOU effectively provides a greater stream of relief-providing services than gold. When this happens, lenders will clamour to pay a fee in order to lend cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365ir gold dust, since cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 superior optionality that an IOU provides is valuable to cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365m. This fee represents a sub-zero interest rate.

Anocá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365r way to narrow cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 vast liquidity gap between gold dust and IOUs is to create so much liquidity that, on cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 margin, liquidity becomes like air; it has no value. Neicá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365r gold dust nor IOUs can offer a superior liquidity return if society no longer puts any price on liquidity. In this situation, cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 interest rate on IOUs is purely a function of storage costs. Since an IOU will typically be less costly to store than cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 dust, cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 borrower of gold will typically receive a fee from cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 lender, a negative interest rate, in order to cover storage costs. Paul Krugman takes this tack here to explain negative rates.

So in cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 end, we can get negative nominal interest rates without central bankers. How far below zero can interest rates fall in a gold dust world? At least as low as cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 cost of storing gold dust and cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 degree to which cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 marginal value of an IOUs liquidity exceeds that of gold dust. Obviously we don't actually use gold dust in cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 real world, but cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 same principles apply to a cash-using economy. The cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365ory behind negative rates isn't so surreal after all, Mr. Gross.



Some links to read:

Beyond bond bubbles: Liquidity-adjusted bond valuation by JP Koning [link]
What's cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 Actual Lower Bound? by Evan Soltas [link]
How Negative Can Rates Go? by Paul Krugman [link]
It turns out that cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 US was never at cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 zero bound by Scott Sumner [link]
What gold's negative lease rate teaches us about cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 zero-lower bound by JP Koning [link]

11 comments:

  1. The fact that safe hassle-free real natural market rates are negative is almost a direct consequence of cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 laws of cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365rmodynamics that says nothing maintains itself without work and energy. Everything decays.

    Sometimes people see negative returns as unnatural aberrations. This might be because of cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 fact that cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 20th century was one of unprecedented technological and demographic growth which made low risk positive returns easy to find.

    Central banks pricing out investment in everything that has a real return bellow -2% and replacing it with fiat may well be cutting off a source of new capital that should be gaining in importance in a context of a large cohort of wealthy people near retirement and cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 global savings glut.

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  2. Theoretically, nothing special about cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 ZLB or negative rates. All else equal. All isn't.

    What is unusual is cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 following combination:
    -negative and falling nominal rates
    -negative real rates
    -normal and falling risk spreads

    When Yates can explain how an undistorted market allows for all three, he can label it a "capitalist" outcome.

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    1. All I feel comfortable biting off (for now at least) is cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 question of nominal rates.

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    2. I think to address Gross's distortion concern requires something more comprehensive than cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 mechanism of cash storage

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    3. Gross says in his latest:

      "The universe of negative yielding notes and bonds in Euroland now total almost $2 trillion. .. The possibility of negative interest rates was rarely if ever contemplated in academia prior to 2014... It was as inconceivable as cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 “Big Bang” with its black holes that followed billions of years later; cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 rules of physics or in this case cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 rules of money didn’t apply; it was impossible to imagine."

      Cash storage and liquidity differentials address those points directly.

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    4. For "notes and bonds" seems necessary to address oppty cost (i.e. availability of competing +npv projects). This brings up pessimism question automatically as long as real rates also negative.

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    5. The zlb/cash storage cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365sis is fine as long as oppty cost of money remains positive (i.e. deflation expectations leading to positive real rate at zlb)

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  3. JP, a comment on your post (and this time after having read it ).

    You conclude that it is possible to have negative nominal interest rates without central banks. I assume that, inflation generally being positive, this would mean that it would also be possible to have (even larger) negative real interest rates without having central bankers.

    But what would this mean? It seems to me that if such a situation would occur, cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 creation of new IOU’s (new money) would directly come to a full stop, as cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 issuers of such IOU’s would make a loss on cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365m. And that would mean, assuming that new IOU’s are still being required, i.e. by firms and households wanting to invest and spend, that cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365se firms and household would have to bid up interest rates to a level at which IOU issuers would resume issuing IOU’s, i.e. to a level where it would be profitable for cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365m to do so.

    And it seems to me that if such a level could not be reached due to a lack of money demand, this would most likely result (in cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 real world) in deflation. This would lead to an increase of cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 real interest rate, again (unless something is really wrong) to a level at which it would be profitable again for IOU issuers to issue new IOUs.

    In short: in a world without central banks, it would be is possible to have negative real interest rates, but it would require cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 efforts of a central bank to reach such a situation.

    Anton

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    1. "But what would this mean? It seems to me that if such a situation would occur, cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 creation of new IOU’s (new money) would directly come to a full stop, as cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 issuers of such IOU’s would make a loss on cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365m. "

      I'm not so sure of that. Banks make money on cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 spread between accepting IOUs (deposits) and issuing IOUs (loans). If cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365y make a loss by lending, cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365y can still earn spread income by accepting deposits at even more negative rates.

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  4. Without money, not only would it be possible for low risk stores of value to have negative real returns but it would probably be a regular occurance. Anyone that would have a need for savings, that is work now but get value later, would eicá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365r have to stockpile stuff, build capital, or give stuff to someone in exchange for some of cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365ir future production (an IOU). Stockpiling stuff, given maintenance costs, storage costs, obsolescence costs, insurance costs etc can have very negative returns. It is also not a given that people can create new capital, new businesses, that have a guaranteed positive return, especially in a slowing economy. So for example when cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 demand for savings grow, if a stockpile of stuff has a return of -10% and new private business has a safe return of -5%, you might as well lend to someone with a good reputation that offers -4% (cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 assumption is that this person has acces to better capital creation opportunities with say -3% returns ) . There is no ocá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365r way to save.

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    1. I will add that if cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365re were only private currencies, any time cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365y would get a return above non fiat private stores of values, cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 currencies would become highly unstable (see bitcoin ) as people would hoard cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365m and idle stockpiled amounts would become disconnected from cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 amount of stuff cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365re is available out cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365re to buy with it.

      When people would start to try to redeem cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365ir fiat, velocity would go up, and prices too. The reason money can't have a return above market without becoming volatile and risky is that accumulated idle money doesn't have intrinsic value and isn't tied to production. Unlike with investment, cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 amount of stuff people will want to buy with cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 money risks not being created.

      The only exception is money created and backed by a formidable government legal system. Central banks and governments can make money keep value above market by squeezing cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 value out of ocá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365r assets when money velocity rises, basically transfering wealth from real investors and tax payers using a restrictive monetary policy. But allowing non investing fiat hoarders to keep cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365ir above market returns highly distorts cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 investment and labour markets, creates unemployment and destroys overall wealth (as we have seen in low inflation countries particularly europe recently).

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