By James H. Nolt
Months ago in an earlier blog, I noted that yields on some European bonds had reached zero. Now it has happened in the U.S. too. The latest Treasury bill (or T-bill) auction yielded such high demand that yields were driven to zero.
Zero yield on bills is equivalent to a zero interest rate. In other words, investors are lending money to the U.S. government for free. This is contrary to economic logic and all of previous interest rate history. What does it portend?
In order to understand the impact of zero interest rates it is crucial to consider the impact on both sides of the transaction. On the side of debtors, if borrowing is cost-free then there is a strong incentive to over-borrow. We will return to that point soon. Yet even more perplexing is the incentive of the lenders. Why would anyone voluntarily lend their capital (which is what buying a T-bill entails) with no return whatsoever?
Buying a T-bill with a yield of zero is similar to holding cash, as cash also pays no interest. One of the main reasons investors hold cash rather than buying assets with a higher yield is that they are bearish. An investor who expects asset prices to fall in the near future prefers not to buy any asset, but to hold cash or cash-like assets, such as T-bills, to hold their wealth in reserve until after prices fall, when they can buy assets cheaper, at a discount. Bears prefer liquidity.
Bulls prefer not liquidity, but leverage. If they expect asset prices will rise and can borrow more cheaply than the current yield on assets, then the more they borrow to buy assets, the more profit they will make.
Remember that T-bills fund government operations, not investors. Yet the low price of T-bills also implies a low price for private bills, since the same market demand that is driving down the price of T-bills also drives down the price of private short-term assets such as commercial paper and repo agreements. In fact, in recent months the annualized interest rate on overnight repo agreements (essentially a one-day loan) is not quite zero, but around two-tenths of one percent.
Of course, few ordinary business people, let alone individual investors, can borrow in the repo market at such extraordinarily low rates. Instead, most repo borrowing (which is measured in the trillions of dollars) funds the trading positions of hedge funds, investment funds, and wealthy private investors. Big banks used to fund their trading desks this way as well until the Dodd-Frank Law forced most such trading off bank balance sheets and into darker corners of the financial system where it is little monitored or regulated.
In other words, the debt leverage that multiplies bearish profits is now extraordinarily cheap. If the cost of borrowing is scarcely above zero, then almost any asset that is increasing in value at all can yield a much bigger profit with increased leverage. Consider an example: If stocks are rising an average of two-percent per year, if you invested all your $1 million in capital in stocks, you could make $20,000 profit. However, if you borrow $999 million in the repo market at 0.2 percent interest, the annual interest cost is roughly $2 million but you can now make 2 percent profit on the entire amount, a total of $1 billion in capital. Your gross profit becomes $20 million, minus the $2 million borrowing cost, for a net profit of $18 million instead of $20,000. Of course, 99-to-1 is a pretty extreme, but not unheard of, amount of leverage. At such low interest rates, bullish gambling with enormous leverage is a highly attractive way to boost profits.
There is only one deterrent to such extremes of leveraged gambling: strategic risk. There is a danger that conditions will change and you will no longer be able to borrow as cheaply or make profit as reliably. In other words, as I have said before, what kills the bull is higher interest rates or falling asset yields.
Extremely low interest rates, such as we now have, can indicate that an economic crisis is imminent because bulls are tempted to make themselves extremely vulnerable using extremely cheap (and profitable) leverage. Simultanelously, bears are actively husbanding liquid reserves, which is exactly why interest rates are so low. As Keynes would say, there is a strong liquidity preference. Its source is bears waiting for the other shoe to drop, for asset prices to fall.
Some will say that the reason demand for T-bills is so high is because of the strong dollar. Foreign investors buy T-bills because they need dollar-denominated assets to hedge against the fall of their own currency. Recently the dollar has been rising against nearly every other major currency in the world.
The problem with this explanation is that if dollar-face value were the only concern, investors could buy a large variety of assets, including New York real estate, Wall Street stocks, and U.S. corporate bonds. The foreign currency hedge argument does not explain why demand is strong for liquid and low-yielding assets like T-bills. Foreigners too must be bearish on dollar assets. They do not want so many long-lasting assets, only ones they can liquidate on short notice. Thus, whether considering the incentives of foreign investors and governments or of domestic ones, this massive flight to liquidity is a sign that bearish sentiment is widespread.
Yes, the stock market enjoyed a modest rally on the very day T-bill yields fell to zero. That is caused by bulls taking advantage of the extremely low cost of credit to increase leverage, buy more assets, and thus push prices up a little more.
However, the flip side of that coin is that short-term yields are near zero because of the massive bearish flight to liquidity. Any bulls who do not soon liquidate their positions and cash-in profits could suffer heavy losses when asset prices fall again, as the bears expect. Bulls’ losses, like their profits, will be magnified by the extent of their leverage.
Thus extremely low interest rates such as we see today are a danger sign. They are a sign that bull and bull positions are both growing rapidly in expectation that asset prices will soon reverse. Keynes calls this sort of time a “culminating point.” Bulls hope to squeeze a little more profit out before the crash. Bears are staying liquid to buy back in after prices fall.
These extremely low interest rates do not in themselves guarantee a major financial crisis, because the relative balance of bearish and bullish forces does matter, but it does mean that dry tinder is accumulating. A conflagration requires only a pessimistic spark.
James H. Nolt is a senior fellow at World Policy Institute and an adjunct associate professor at New York University.
[Photo courtesy of the U.S. Treasury]