Investors Really Haven’t Thought Through The Full Implications of Negative Interest Rates

Negative interest rates are coming to a market near you. The Bank Of England recently hinted at the possibility of  negative interest rates, and New Zealand is conducting a study.  Other Central Banks are currently less enthusiastic, but they might reconsider in the near future.

Get Our Activist Investing Case Study!

Get the entire 10-part series on our in-depth study on activist investing in PDF. Save it to your desktop, read it on your tablet, or print it out to read anywhere! Sign up below!

Q2 2020 hedge fund letters, conferences and more

No doubt negative interest rates are  bad for your saving account.  Yet that is just one effect. Few people have really thought through the full implications of negative interest rates across markets.   Here are just a few implications to consider.

Global Retirement Crisis

Negative interest rates will exacerbate the global retirement crisis.  The Social Security Trust Fund is only allowed to invest in US treasury Securities, so if rates went negative for any length of time, Social Security would become insolvent.  Negative rates will also make government and private sector pension funds insolvent.  Pension funds discount future obligations backwards so lower discount rates lead to higher obligations in the present day.  More concerning is the fact that pensions are generally obligated to invest a significant portion of their assets into “safe assets”, which are the first to start yielding a negative rate.  As a result, negative rates would create a destructive feedback loop in which pension funds erode their capital base.

Banks and Insurance Companies

A similar phenomenon is at work with banks and insurance companies.  Banks must maintain a portion of their assets in a reserve account overseen by the central bank.  The rest can be lent or invested.  This system works when rates are positive.  Yet when interest rates are negative, banks are effectively punished for providing credit to the economy.   Complying with capital adequacy rules in an interest environment will actually erode a bank’s capital base.

Insurance companies make money by collecting premiums in advance of paying claims, and investing these premiums.  Regulators also require them to maintain a significant portion of their assets in government debt and other “safe” assets.”  If rates go negative, insurance companies will have to raise premiums and/or underwrite less business.

Options Pricing

Hedge funds, banks and other financial institutions  hold OTC options or swaps that must be valued using black scholes models in between the time of initiation and expiration or exercise. The amount of collateral posted by counterparties is also based on these valuation models.   Even funds with vanilla sounding strategies might supplement the portfolio with these derivatives.  The Black Scholes model is one of the pillars of modern finance, but it cannot compute when the risk free interest rate is negative.  People might be able to dust off old Brownian motion models, but there won’t be an initial consensus on what model to use.   As of the end of 2019, the notional value of outstanding OTC derivatives was over $500 trillion, according to the BIS,  so any switchover in valuation method will create serious legal issues and unintended consequences throughout the investment world.

Markets aren’t going to close just so firms can rewrite their valuation policies.  Since many asset allocation models use percentage targets for different asset classes, this will have second order impacts in other markets as well.   This is not a theoretical concern- it will impact what types of risks can be hedged and how capital can be allocated throughout the economy.

Recalibrated Models

Many of the assumptions that have historically driven investor behavior will no longer apply in a negative rate environment .   If  negative rate do become a long term phenomenon, get ready for a slew of unintended consequences in places you didn’t expect.

The post Investors Really Haven’t Thought Through The Full Implications of Negative Interest Rates appeared first on ValueWalk.