Interest rates: through the looking-glass

Will the Reserve Bank of Australia (RBA) be obliged to consult the ‘unconventional’ monetary policy playbook? And which such policy should they choose - quantitative easing (QE), long-term lending facilities or even negative interest rates?

“Interest rates are deemed to be the reward for saving and are therefore positive, end of story.”

Negative interest rates are especially bamboozling. It’s as if we have accidentally climbed though Alice’s looking-glass to where all logic is backward.

How do we make sense of this new world? Awkwardly, economic models tend to treat time like location - interest rates reflect the preference for commodities in the current location over those in another location, namely the future.

Nothing in this thinking ensures interest rates are positive - it’s just assumed. Interest rates are deemed to be the reward for saving and are therefore positive, end of story. But this is not a good way to think about them. It’s no wonder negative interest rates are proving so hard to accept.

Saving or waiting

John Maynard Keynes provides a better starting point. Through his investing he amassed a fortune of around $30 million in today’s terms, even after suffering heavy losses in the great crash of 1929.

His ideas can help us understand how QE might play out in Australia. And, although the case of negative rates is more difficult, Keynes’s framework provides some insights.

For Keynes it was “obvious that the rate of interest cannot be a return to saving or waiting” once it is observed that savings in cash earn little or no interest, even though the amount saved is the same.

There must be another reason.

Instead, “the mere definition of the rate of interest tells us in so many words that the rate of interest is the reward for parting with liquidity for a specified period”. Interest is the reward for lending money.

Conservation of matter

Keynes also provided guidance on asset selection. We often hear reports of investors “all moving out of equities into bonds” or vice versa.

Taken at face value, these ideas violate a kind of financial law of conservation of matter - it simply can’t happen. Investors might like to make this switch but they won’t all be able to. All assets that exist must be owned by someone - sales cannot happen without buyers.

The menagerie of investible assets is manifold - stocks, government bonds, corporate bonds, commodities. And money. Investors must choose between all these different assets. Some investors are fixed in one type by legal requirements but others are free to wander the investment zoo seeking out better returns.

Consequently, wealth tends to flow from one asset type to another until the advantage from moving disappears. Asset prices adjust to the point where these mobile investors are indifferent between all the (risk-adjusted) expected returns available. This adjustment process creates one-time winners and losers but the nature of financial markets makes these moves almost impossible to predict.

QE, in which the central bank purchases pre-existing financial assets with newly issued claims on itself, affects the financial markets like shifts in tectonic plates. These new claims - money - are new competitors replacing previous exhibits in the zoo.

According to Keynes, the potential returns for various asset types are driven by the combination of a few basic factors. Dividend and cash payments - what he called yield - make up one factor. Working against this, assets such as commodities have carrying costs due to wastage and storage.

Keynes also stressed the importance of another factor - liquidity. Ownership of liquid assets like money and bank deposits provides psychological comfort that “lulls our disquietude”. These assets have no yield or carrying cost but instead offer an intangible return - we are happy to hold them even though they generally pay no interest at all.

Despite derided as a Carrollian “grin without a cat”, this implicit liquidity premium forms Keynes’s theory of ‘liquidity preference’ - interest rates rise and fall with the supply and demand for liquid assets.

By increasing the supply of liquid assets, QE affects this liquidity balance and triggers a re-evaluation of all other asset prices.

Through the looking-glass

What about negative interest rates?

The European Central Bank and the Bank of Japan have both adopted policies which impose costs on holding money - negative rates on central bank deposits. As investors roam the asset zoo, this has forced a recalibration of prices and returns for all existing exhibits.

Before negative official deposit rates, holding liquid assets only involved paying an implicit liquidity premium. Now it also has an explicit cost. Compared with Keynes’s definition, negative rates on central bank deposits are not really ‘interest rates’ at all. These negative rates are not the reward for parting with money, they are the cost of holding liquidity - money now has an explicit carrying cost.

This new carrying cost then disrupts the entire market - rather than holding negatively earning money for liquidity, why not place surplus funds in the repo market (short-term lending against high-quality collateral, like government bonds)? Because it too has adjusted and now repo rates are negative across the Eurozone.

Okay, but negative repo rates mean being paid to borrow and buy long-term (and formerly higher yielding) bonds. It’s no surprise, then, yields on longer-term assets have fallen below zero to remove this profit opportunity. And so on.

Negative rates are new and will take time to become familiar. But the new mantra is largely the same as the old one: if you want liquidity it will cost you. It’s just the way you pay that’s changed.

James Culham is Director, Institutional Portfolio Management at ANZ