Negative Interest Rates Are Coming.

The debt and deflation disease is gradually working its way through the economic body…moving from the extremities to the vital organs, what are the financial doctors prescribing? A massive injection of negative interest rates…in the hope of creating more debt. Brilliant!!!, But will the injection of negative rates achieve the desired objective? To answer that question we have to understand the mechanism of negative rates. Quantitative easing (money creation) and negative interest rates are the central bankers’ stimulus tag team.

‘The European Central Bank has unleashed a bigger than expected package of measures to stimulate the eurozone economy, with expanded quantitative easing [QE], incentives to banks to increase lending and further [negative] interest rate cuts.’ — Financial Times 10 March 2016.

Firstly, central banks release excessive levels of QE into the system. At present, the European Central Bank (ECB) is printing €80 billion a month to buy government and corporate bonds from the private sector. What do the private sector banks do with that money? It ends up in their cash reserves.

Under the complex rules of banking, solvent banks must satisfy minimum cash reserve requirements…a percentage of depositor funds to be held with the central bank. For example, a bank with deposits on its books totaling $100 billion might be required to have a 10% cash reserve requirement ($10 billion) lodged with the central bank. When there is excessive QE (money creation), a bank’s cash reserve level can easily exceed the minimum reserve requirement…this is a deliberate ploy by central bankers. The excess cash reserves (manufactured by QE) are then penalized under the negative interest rate regime. In the above example, if the bank’s cash reserves ballooned to $30 billion, the central bank negative rate would apply to $20 billion (the amount in excess of the 10% cash reserve requirement). The ECB interest rate is MINUS 0.4%. Therefore, based on having $20 billion in excess reserves, a European bank would be charged $80 million to deposit the surplus requirement with the ECB. Not an insignificant amount of money.

Here’s the simple version: Central banks create the money, out of thin air, to give to the banks. The banks then give it back to the central bank and are penalized for doing so. In theory, the name of the game is to lend, lend, and lend that excess cash. But theory and practice do not always align.

Alternatives

What are the options available to the banks to minimize the central bankers’ punitive strategy?

Wear the cost. Take a hit to the bottom line. Move deposit rates into negative territory. Effectively offsetting the central bank costs by penalizing depositors (even harder) with negative interest rates. Increase lending to reduce the level of excess reserves. At present, banks have not passed on the costs of negative rates to deposit holders via negative interest on bank accounts and term deposits. However, if central bank holding rates go much lower — let’s say to MINUS 1% — the banks may well be to forced pass on this cost to savers. This would have a disastrous effect on the psychology of savers…making them tighten their belts even further in a deflationary economy. Another unintended consequence could be that banks find savers deciding to close their account/s…preferring to hold physical cash in personal safes or safety deposit boxes at the bank.

Alternatively, savers could say ‘what the heck’ and, in their desperate search for yield, they could decide to buy into a UK commercial property fund. In doing so, they’d find the redemption facility temporarily suspended, and the fund’s assets devalued by 30%.

Oops, I almost forgot, this is what’s already happened to investors chasing yield. While chasing a few extra percentage points of returns, their capital is cut-off at the knees. A rush to hold cash could see central banks ban the withdrawal of physical tender above a certain limit…say a few thousand dollars. We then move to a cashless, electronic system…of course, this will be done for our protection against crime bosses and terrorists.

Or we could have the last option, where banks are flooded with demands from people keen to borrow money, embarking on yet another decade-long spending spree. Possible, but highly unlikely. There are no good outcomes with negative interest rates. The lower rates go, the greater the risk of unintended and potentially disastrous consequences coming into play. Negative rates are like taxes. People start looking for creative ways to avoid them. Central bankers cannot possibly know how investors will react when faced with the prospect of losing their savings. We’ll lurch from one crisis to another. Blind ignorance is no impediment to central bankers. ‘Crash or crash through’ appears to be their reckless creed. In due course, their actions will see asset markets looking like the shop windows in Rome.

Original article by; Sharecafe Commentary
Negative Rates, Markets, Outcomes
By Vern Gowdie- 14/07/2016.