The math is a little beyond introductory algebra,but what is clear is that some of our most important pricing models are not designed to accommodate negative interest rates. What’s a regulator to do?
Now that interest rates have become very low or even negative it is no longer reasonable or even possible to use Black’s model since it does not allow negative rates. Of the four models only the Bachelier model allows rates to become negative. In the other three cases when rates may become negative it is necessary to modify the model by adding a shift, ss, to the forward rate. For example, the shifted or displaced version of Black’s model obeys
“For years, central bankers in the developed world have been trying to battle poor economic growth and weak demand with ultra-low, and even negative, interest rates. It’s not working.”
Einstein said, “Only two things are unlimited: the universe and human stupidity. And I am not too sure about the first.” What could be scarier than adding more confusion to already confused thinking? Let’s face it: revaluing already illiquid securities in the midst fo a financial crisis when all willing buyers and sellers have gone shopping for new underwear confirms Einstein’s instincts about unlimited human stupidity.
Even a three-year old can see the problem with the following scenario. Imagine a moment of market contagion. Based on seasoning and performance, holding onto illiquid securities would generate an expected loss of $100 million. But when the accounting and the regs require using “exit values” rather than the price set by “willing buyers and willing sellers” the result is a mandated mark-to-market loss resulting in an immediate impairment of $900 million. OTTI (other than temporary impairment ) .
Surprise surprise! The market tanked today. Maybe you should just turn off your screen just go and see a movie?
I highly recommend you see Dr. Dolittle and his Schizophrenic Push me-Pull you. The Push me Pull you is a two-headed llama. One llama is a tough- love interest rate hawk who wants to go right; the other a llama is an easy-money dove in favor of unlimited quantitative easing and negative interest rates policy.
Rex Harrison as Dr. Dolittle, Janet Yellen (llama on left) and Mario Draghi (on right), the parrot’s name is NIRP
The story is about the world’s central bankers portrayed by this lovable but sexually frustrated beast that wants to go in different directions– one want rates so low they drop below zero and the other wants to cool an over-heated market. Needless to say, this is a horror film, not for the squeamish and (warning: spoiler alert) it does not end well.
Classic bubbles, perpetuated by easy money, are recapitulations of Newton’s law of gravitational attraction: “what goes up must come down.” Negative interest rates, on the other hand, move us into an alternate universe, the weird and whacky world of quantum finance where reality is nothing but an illusion– but a very persistent one” as Einstein said.
As negative interest rates have been embraced by half the central banks, the Fed’s wait-and-see posture today seems more like an illusion than reality: that a rate hike will be too hard to resist. The market tanked instantaneously taking this change in market sentiment as the harbinger of an end to the era of easy money.
Cheng and Eng Bunker figured it out and actually fathered children
Dr. Dolittle’s Push me-Pull you is a reminder that when half the world is betting rates go up and half betting they will go down, trouble lies ahead. In the end, everyone gets screwed.
It also reminds us that central bankers should not play dice.
Abe Maslow famously said, “when your only tool’s a hammer every problem starts looking like a nail.” Seems the Fed has figured out it needed a few more tools in the toolkit. But it’s not clear what job their new tools — interest on reserves and large-scale asset purchases — are good at fixing.
A little bloodletting never hurt anyone? Never helped anyone either.
There are no right solutions to the wrong problem. Perhaps it might make sense to make sure we are solving the right problem. Said differently, perhaps the problem is that we are not sure what the problem is. That is depending on what your definition of “is” is. Oy Vay!
As the lender of last resort, the Fed gets a lot of leeway in the midst of a global financial crisis. But here we are eight years out and it looks like the Bail-out and its ad hoc solutions like TARP and quantitative easing etc. etc. might just have been kicking the can down the road. The coercive nature of low (let alone negative) interest rates has the effect of getting investors, consumers, and savers to do things that they are not naturally inclined to do. The wide disparity in opinions from “experts”, consumers, and investors about the wisdom of NIRP is unto itself terribly troubling.
Basically,it would appear the Fed has plum run out of ideas, at least good ones. Blood-letting was the medicine of choice for eons. Maybe the Fed needs to find some better ideas. Until then welcome to the world of Oyconomics.
Unfortunately, he was right in 2005– predicting the collapse of the financial markets 3 years later. A controversial rock star, (not unlike our own Dr. Doom, Nouriel Roubini) Raghuram Rajan is exiting as head of India’s central bank. His unwillingness to accommodate less disciplined critics displeased politicians and businesses big and small so it was time to shoot the messenger.
Not a fan of low or negative interest rates Rajan sees the world’s central bankers falling into a trap– where low rates become the heroin of the financial markets. The inability to raise rates will cause distortions that could imperil the global financial markets — once again.
As plain vanilla risks can be moved off bank balance sheets into the balance sheets of investment managers, banks have an incentive to originate more of them. Thus they will tend to feed rather than restrain the appetite for risk. Banks cannot, however, sell all risks. They often have to bear the most complicated and volatile portion of the risks they originate, so even though some risk has been moved off bank balance sheets, balance sheets have been reloaded with fresh, more complicated, risks. In fact, the data suggest that despite a deepening of financial markets, banks may not be any safer than in the past. Moreover, the risk they now bear is a small (though perhaps the most volatile) tip of an iceberg of risk they have created.
Is Carnegie Mellon’s Marvin Goodfriend about to become a monetary policy superstar or is he leading the Fed down the primrose path into a black hole? His paper, “THE CASE FOR UNENCUMBERING INTEREST RATE POLICY AT THE ZERO BOUND” was a hit at the Jackson Hole Symposium– the little soiree for Central Bankers and the Criminally Insane. It would appear notwithstanding denials from Janet Yellen and others the Fed is preparing itself for negative interest rates. Or at least studying up.
Carnegie Mellon’s Marvin Goodfriend is also affiliated with the National Bureau of Economic Research
Goodfriend’s exegesis on negative interest rates and the lower bound problem is a must-read but be prepared–even wonks and policy nerds will have trouble processing his analysis and rationale that advocates the use of negative interest rates by the Fed to eliminate the lower bound problem.
In Goodfriend’s own words negative interest rates take a little getting used to.
In I may summarize, according to Goodfriend and others for monetary to be efficient and effective when markets are under pressure short-term rates need to be about 2 1/2% lower than longer-term yields (i.e. 10 -year treasuries). Historical this differential is what it takes for monetary policy to get enough traction to induce investors to do otherwise unnatural acts. Given the institutional structure of the markets, it takes a steeply positive yield curve of 250bps to push (i.e. coerce) investors out the yield curve and down the credit curve accepting riskier assets in search of acceptable yield. With ten year treasuries at 1.5%, this implies central bank reserves and hence the inter- bank lending rate would need to be around -1%.
The idea of negative nominal interest rates takes some getting used to, but it should be possible to make the public aware eventually that such flexibility in short term interest rates is well worth it to provide better employment security and more secure lifetime savings. –Marvin Goodfriend
So why wouldn’t investors just hold cash in the form of paper money. Goodfriend’s logical extension is to eventually get rid of paper currency altogether. On paper (pun intended) it is theoretically “interesting” (as in “how was your blind date last night?”) But Goodfriend’s solution might just turn out to be the pretty girl at the ugly party.
Perhaps, Goodfriend and central banker are conflating monetary policy prescriptions with how investors and consumers actually behave. Disconnecting monetary policy and short-term interest rates with real corporate finance that uses simple tools such as net present value, hurdle rates, and IRRs is the stuff massive asset bubbles are made of.
Individually most investors are dumb as bricks but as a whole, they are brilliant, yet ruthless. When they don’t understand something the tend to vomit in a projectile manner. You can read Goodfriend’s paper and see if most consumers and/or investors will understand it. And that is where the problem lies. Aristotle said horror vacui or nature abhors a vacuum and investors abhor uncertainty. And those are the only two things to be certain of.
[Editor: Got to love these bankers north of the border. With one of the soundest banking systems here’s what the Bank of Canada had to say about negative interest rates. ]
Considerable uncertainty remains, however, as to precisely how far below zero the policy rate could go before markets became materially impaired or the demand for bank notes increased significantly. Furthermore, the Bank’s estimate will likely evolve over time as we monitor the experiences of other central banks operating in a negative interest rate environment or observe how Canada’s financial system would adapt to a negative rate environment. In practice, should rates be lowered below zero, the risk of triggering unintended consequences would need to be assessed carefully, based on a detailed and continuous monitoring of indicators of market functioning and the demand for bank notes. In the event that the Bank judged that the lower bound was being approached, it would clearly communicate that information to the public.
Negative interest rates have split the world’s central banks into camps: the believers, agnostics, and atheists. This lack of consensus has itself become an untenable risk. Deploying negative interest rates as a strategy will likely result in unintended consequences and new types of financial co-morbidities. The financial, social and political risks are both sizable and poorly understood.
Perhaps the most compelling reason for central bankers to implement NIRP strategies is there are no other tools left in the monetary toolbox. And that’s not a very good reason. But as Samuel Johnson said, “Nothing focuses the mind like a hanging.”
Follow our ongoing series, “The Real Risks of Negative Interest Rates, Unintended Consequences, and Financial Co-morbidities” at www.negativeinterestrates.com.
Topics will include:
Negative interest rates, cap rates, multiples, net present value and IRRs
Negative interest rates, the fed funds rate and the 10 year
Negative interest rates and the coercive nature of maturity extension
Negative interest rates and asset class reallocations
Negative interest rates and refinancing and rollover risk
Negative interest rates and actuarial assumptions
Negative interest rates and IRAs
Negative interest rates and the yield curve
Negative interest rates and credit spreads
Negative interest rates and hedging
Negative interest rates and market illiquidity
Negative interest rates and mark-to-market
Negative interest rates and mortgage securities
Negative interest rates and the rating agencies
Negative interest rates and the regulators
Negative interest rates and multi-legged interest rate/currency swaps
Negative interest rates and consumer and investor expectations
