The Fed’s latest interest rate cut has us contemplating the insanity of negative interest rates. Trillions of dollars of sovereign debt instruments around the world now bear negative interest rates.
Imagine what that means.
You work hard and save. Your savings represents capital, which is the lifeblood of economic growth. Your deferred consumption allows for future prosperity. Didn’t we all learn this as children in the tale of the grasshopper and the ants?
But in a negative interest rate regime, the ants are penalized for saving for the future. Buy a negative interest rate bond for $1,ooo today and get $900 back at maturity. In such a never-before-seen, topsy-turvy world it makes sense to consume today since saving for the future is a guaranteed loser.
Negative interest rates are a powerful means of destroying capital – and capitalism itself. No wonder Jeff Deist, the president of the Mises Institute, has titled an article on the subject “Negative Interest Rates are the Price We Pay for De-Civilization.”
Yet observers from Alan Greenspan to Ron Paul tell us that negative interest rates are on their way here to the US. We know that the Fed even considered implementing negative interest rates during the last financial crisis.
Since rational people would just hold on to their money themselves instead of lending it for a guaranteed loss, what is going on? If it is so economically unnatural and unprecedented in human history, why is the world awash in trillions of dollars of negative yield bonds?
In short, it is the work of central banks like the Federal Reserve.
In the financial centers and trading desks of the world’s banks, funds, and brokers, traders and fund managers are buying negative yield bonds precisely because they are speculating that there will be more foolish central bank intervention.
Remember that bond prices are like a teeter-totter. When interest rates go up, the market price of bonds go down; when interest rates go down, the market prices of bonds goes up.
So in the major financial centers traders think that central banks will force rates even lower allowing them to profit by selling the negative yielding bonds to another sucker at higher prices.
But they are walking on the razor’s edge. And they have taken the entire world’s financial system along with them.
Here’s Deist: “Of course, it must be noted that rational purchasers of negative-yield bonds hope to sell them before maturity, i.e., they hope bond prices rise as interest rates drop even lower. They hope to sell their bonds to a greater fool and generate a capital gain. They are not ‘buying’ the obligation to pay interest, but the chance of reselling for a profit. So purchasing a negative-yield bond might make sense as an investment (vs. institutional and central bank bond buyers, which frequently hold bonds to maturity and thereby literally pay to lend money).”
That’s fine. And it works according to plan. Until interest rates rise.
Then instead of capital gains, the holders of trillions of dollars of negative yield bonds will suffer huge capital losses. The losses, says Deist, of those holding trillions of dollars of bonds could be staggering.
It is, in other words, exactly what Ron Paul called it, a bond bubble – the biggest bubble in history. Massive. Global.
And when it pops it will take everything with it: bonds, currencies, stocks, real estate…
It will take everything with it except gold.