European countries' less-than-zero club is becoming a popular one. Could it happen here in the States?

February 25, 2015 — 7:00 PM UTC by Guest Columnist Stephen J. Huxley


Brooke’s Note: I have heard it for more than a decade. Interest rates can’t go much lower because they are so close to zero. But of course they can go infinitely lower. Ludicrous as it sounds, negative interest rates are not only possible, they pop up in civilized places with thriving modern economies like Japan and Europe. For the masses of brokers who want nothing more than to sell alternative investments, such a trend toward interest rate negativity is like manna from heaven. Aside from being an alternative to long-only SMAs and mutual funds, they can claim the mantle of being a sanctuary from, in a sense, paying to not invest. With these thoughts in mind, I went looking for somebody who could inject some perspective into the specter of negative interest rates. I found him in Steve Huxley who has helped us out in these yield matters before. See: The cost of waiting for interest rates to rise.

RIA’s have a fiduciary responsibility to care for their clients and stay up to date on what is happening in the financial world to protect their clients.

In that regard, a rare thing has happened recently in Europe that may have some alternatives investment salespeople calling to make a pitch or create some worry in the minds of clients who pay attention to such things: bond yields have turned negative for some five-year sovereign debt issued by some countries (Finland, Denmark, Netherlands, Austria and Sweden). It is negative on four-year debt from France and Belgium, six-year debt from Germany, and for 13-year Swiss debt. (See this article from the Wall Street Journal and this item from Yahoo!)

So the obvious question arises: Could yields on longer-term U.S. Treasuries turn negative like the cases in Europe? If they did, could they last for a long time?

Bond yields for five- or 10-year U.S. debt, which is where most RIA clients are invested, have remained low for longer than most people expected, but has never gone negative. The figure below shows the yield on the 10-year Treasury back to 1800. Yields on 30-day U.S. T-Bills have been slightly negative several times over the past few years if you factor in the cost of trading. (The Federal Reserve shows zero yields for the days this phenomenon occurred.) See: The 5 biggest errors of intellectual omission by RIAs — in fact, most advisors.


Yields on the 10-year Treasury back to 1800
Yields on the 10-year Treasury back
to 1800

While anything is possible in the short run — especially when politicians get involved — the economic fundamentals of bonds suggest that it is doubtful negative rates will occur in the United States — long considered the safest investments on earth — and equally doubtful they will last long in Europe. See: In search of alternative income solutions in the current low-yield environment.

There may be a few circumstances, of course, where interest rates turn negative for short periods of time. Economic upheaval may generate massive demand for safety, echoing the concern of Mark Twain: “I am more concerned with the return of my money that return on my money.”

If investors thought U.S. Treasury bonds safer than any other bonds, rates could become negative as they have in Europe. Nominal rates on TIPS could become negative if there were major inflationary concerns. See: The cost of waiting for interest rates to rise.

But it would be strange indeed if nominal rates turned negative for very long because an investor can always refuse to invest in anything and get zero return. Only those with very large stashes of cash will be willing to pay for the privilege of depositing their wealth in a bank.

It’s about time

To help clients understand this, it may be necessary to drill down to bedrock and explain exactly what causes interest rates to be positive in the first place. Interest has been with mankind for a very long time; it is mentioned in Exodus, the second book of the Bible. Babylonian tablets also contain records of transactions involving interest payments, i.e. paying back 12 bushels of barley corn after the next harvest in payment for 10 bushels today.

Common explanations for positive rates include inflation, government policies and perhaps the expectation of rising standards of living. But theoreticians believe there are deeper root causes that stem from our nature as human beings and from the dynamic property of time itself.

The first root cause is compensation for deferred gratification. The theory is that we all have “positive time preferences,” meaning we want what we want when we want it — now, not later. The default preference is for immediate gratification, but we will wait if there is some reward for doing so. That is why young children prefer to eat dessert first and have to be taught to wait until they get some nutrition. By the same token, we will pay interest on a credit card to buy things to enjoy now to avoid the pain of waiting. See: FPA Retreat 2012 shines spotlight on the emotional and psychological dynamics between advisor and client.

Positive thoughts

The second explanation for interest rates being positive has to do with risk. Positive time preference isn’t just the result of childish impatience. It is a rational response to what physicists call the “dynamic irreversibility of time” and the risk it creates. Once a dollar leaves your direct control, there is always some probability that you won’t ever enjoy the gratification it could have provided.

The investment may go bad, the record of the deposit may be lost, or something may happen to you — perhaps you die in an automobile accident before getting repaid. In such cases, your gratification wasn’t deferred; it was lost forever. You therefore must be compensated for taking that risk. You want more than your dollar back — you want interest! See: Why the only thing bigger than the bond bubble is the bubble of bond doom-sayers.

Will these underlying reasons for positive interest rates ever change? It is doubtful. What we are seeing in Europe are temporary aberrations that will likely disappear within a year, even with the bumbling economic policies of some of Europe’s current leaders. Most of them will hopefully be gone in a few years also.


_Stephen J. Huxley, Ph.D., is chief investment strategist and founding partner of Asset Dedication LLC, and professor of business analytics at the University of San Francisco. He has received top awards for teaching, research, and service at USF, and published in academic journals and conferences. He co-authored the book Asset Dedication (McGraw-Hill 2005) with Brent Burns, co-founder and president of Asset Dedication LLC.

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