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Interest rates and the obscure world of negative yields

Few of us think about interest rates and yields on investment except when we take out a loan or invest our savings. But unbeknownst to us, interest rates are the bricks out of which much of our economic infrastructure and intuitions are built. Perhaps knowing its centrality, and the ease with which it can impoverish and enrich people over a short period, the Babylonian king Hammurabi, in the 1700 BCE put a legal maximum of 20% on interest rate. Nearly two millennia later, Brutus in 1st century BCE charged the city of Salamis 48% on a loan. And now, another two millenia later, new smart contracts in the cryptocurrency repurchase markets often begin at 4.99%. In short, interest rates, along with sex and jealousy, have been humanity’s oldest preoccupations.

Yet, if asked what exactly is an ‘interest rate’ — the answers to this question are often tautological. Most people explain away interest rate as that additional amount paid over the original borrowed amount. A more useful way to conceptualise interest rate is to think of it as the premium demanded by a lender to part with his monies across time. This premium, when viewed from the lender’s side includes the risk of lending to a person or institution (often called counterparty risk) and a compensation for parting with his liquidity (cash today is substituted for uncertain cash tomorrow). The same premium, when viewed from the borrower’s side, includes growth prospects (what rate of return can this borrowed amount generate) and the opportunity cost of borrowing today versus tomorrow. Thus, interest rates can be thought of as an assemblage of market clearing premiums — an equilibrium solution, if you will.

Push-and-pull

By and large, irrespective of who does the borrowing — governments or households or individuals — this push-and-pull of premiums is constantly at work. When governments borrow, usually by issuing bonds (they receive investor monies and issue a promissory note to pay it back over time), the government bonds offer the investor a promised rate of return over the life of the bond (called the “yield” of the bond). For much of modern economic history, particularly since World War II, this ‘yield’ has been positive. This is to be expected. Investors of bond expect to make a positive return when lending to any government. Nearly 20 years ago, more than 50% of the world’s bond market offered yields greater than 5% per year. Now, only 3% of the world’s bond market offers yield greater than 5% per year.

Why lend

What makes matters strange today, or even surreal, is that nearly 27% of the world’s bonds offer negative yield. More explicitly, around $16 trillion have been lent out by lenders who expect to receive less in return over time. [To understand the size of this figure, remember, India’s estimated nominal GDP in 2019 is $2.9 trillion]. This is true of German, the Swiss, the Danes, the Swedes, the Japanese government bonds and so on. And there is increased apprehension, negative yields will follow into the United States. On the borrower’s side, Denmark’s third largest bank, the Jyske Bank, now offers a 10-year mortgage at -0.5%. For many, who hear of negative yields for first time — up is down, down is up. The obvious question is why do lenders lend money in order to receive less in the future? While individual institutions may have specific reasons, the answer or rather answers, to this question when we think of large economies en masse is not entirely well understood. At best, we have proximate answers.

Low risk assets

While, negative interest rates have often been used by various central banks in the past to dissuade their large financial institutions from sitting on cash-equivalents and nudge them to lend it to the wider economy and aid in growth — the fundamental drivers of negative yields are more obscure.

Two principal arguments have found adherents. One explanation is demographic. As advanced economies continue to age, their investors prefer extremely low risk assets which may well earn negative yields but largely keep the principal safe. Thus, they prefer safety of principal over all else.

The second line of argument is that post 2008 crises, “tail” risk — unexpected asset valuation declines — has increased. Thus, large institutions now overwhelmingly prefer liquidity over maximising growth prospects and therefore go out of their way to pay extra for liquid government bonds (which increases its price and lowers the yield).

There are other short term explanations too — fears of recession over next 18 months, lack of “safe” assets in the world etc., None of these explanations offer us the satisfaction of a precise answer. For now, negative yield is the elephant and investors in the advanced world are like the blind men who seek to describe the animal after touching its tail or trunk.

Keerthik Sasidharan is a writer and lives in New York City.

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