BarroMetrics Views: A Bazooka to Backfire?
So, QE is now taking the form of negative rates. Some commentators have called negative rates a bazooka.
In this blog, we’ll be considering the questions:
- What are central banks attempting to achieve with negative rates? And,
- Are they likely to be successful?
But, firstly we need to consider what exactly does the term ‘negative rates’ mean?
In its simplest form, the term ‘negative rates’ means that the lender pays the borrower, e.g. a depositor pays the bank interest for the privilege of depositing its funds in the bank.
The aim of the central banks is to encourage the populous to spend rather than to save money. In this way, central banks believe they will be able to stimulate the economy.
So we now come to the central question: do negative rates achieve their purpose?
The fact is they don’t for two reasons.
Firstly, in a low rate environment, commercial banks find it difficult to make money on loans. And, in the United States, the Fed is paying commercial rates for its deposits with the St. Louis Federal Reserve. As a consequence, commercial banks prefer to deposit with the St. Louis Fed Reserve rather than to Main Street (see Figure 1).
There is no evidence to suggest that negative rates increase economic activity.
But there is an even more important reason why negative rates failed to achieve their aim: they distort and corrupt pricing in capital markets.
During normal times, investors have a choice between investing in stocks that pay a dividend or in bonding yields. Usually, if we invest in stocks, because they are a riskier asset class, we seek a safety moat. For example, Benjamin Graham suggested that the moat should be 5% more than corporate bond yields.
Let’s see what’s happening in the current environment.
McDonald’s who have had no income growth for about two years or more and the stock is paying a dividend yield of 2.8%. Its current share price represents around 27 times earnings.
In normal times, we would not expect investors to be purchasing MCD given the lack of growth and the 27x earnings. But, these are not normal times. As Figure 2 shows, MCD has been in a solid uptrend since September 2015.
Because investors are desperately searching for yields. If the bond market won’t provide it, investors will move into stocks. The problem is, when rates start to rise, stocks like MCD will fall.
Despite the lack of evidence that negative rates will bail us out of the doldrums, every single country of note is now following the same tune: from the US to China, to the EC. The central banks have managed to turn what would have been a serious recession into a disaster waiting to happen.
FIGURE 1 AMB
Note the sharp rise in deposits since QE. This is money not used for lending to Main Street
FIGURE 2 MCD