JUST because a “cure” works within certain parameters does not mean it’s a universal panacea that can be applied to all ailments under all circumstances; not recognising that is folly.
The world as we knew it has changed... terrifyingly. One standout example is US President Donald Trump’s selfish, myopic, narrowly nationalistic actions aimed at hurting China — our planet’s largest national contributor to aggregate global GDP growth.
That’s not only causing China’s quarterly GDP growth figures to fall, but also decelerating global trade.
That nudges our entire world closer to recession. Under normal circumstances, I don’t fear a recession. It’s part of the conventional business cycle of expansion-peak-recession-trough before a country’s economic expansion kickstarts a new cycle.
However, the excessive levels of monetary policy meddling by central bankers these last 11 years have brought about a perilous situation.
To understand why, let’s take things a step at a time:
1. Trump’s belligerence toward China has decelerated global trade flows.
2. GDP growth rates for most countries are falling.
3. To counter such problems in the past, central bankers found that dropping interest rates helped jumpstart growth for two reasons:
a. Lower interest rates made it cheaper for businesses to borrow money for expansion; and
b. Those same lower rates also made it less attractive for savers to set money aside in bank deposits.
4. The ensuing credit expansion and reduced savings rates led to increases in the consumption of goods and services, which raised the velocity of money flowing through a country’s economic arteries and thus improved its health.
Novices in economic theory might wish to reread those four steps.
The problem, of course, with a cure that works for a while is so-called experts extrapolate its applicability beyond the bounds of reason.
That has already happened. Some European central bankers began toying with a page torn from an old Japanese playbook: negative interest rates.
NEGATIVE INTEREST RATES
As they slashed interest rates repeatedly, each time with less effectiveness, the floor beneath gave way.
According to the Switzerland-based Bank for International Settlements (BIS), which tracks such things, in September this year, US$17 trillion of the world’s government and corporate bonds was negative yielding. That’s a lot: equivalent to one-fifth of Earth’s total annual GDP!
Thankfully in the last several weeks that quantum of negative yielding debt has fallen a little because some bond yields have moved higher (back above zero per cent a year) as their corresponding bond prices have fallen as wiser fixed income investors shook off their irrational exuberance in bidding up bond prices too far, too fast in their rabid quest for yield.
But other investors have not mended their ways and we still have too much negative yielding debt on Earth, which is weird.
Negative interest rates mean that money tomorrow is worth more than money today.
That’s odd because basic economic theory, predicated on conventional positive interest rates, teaches us that money today is worth more than money tomorrow.
To better understand the ramifications of both positive and negative interest rates, here’s a thought experiment covering three scenarios, 2 per cent, 0 per cent and -2 per cent, over one year.
If in each case we start with RM100, here’s what happens after a year:
1. 2 per cent growth;
2. No change; and
3. 2 per cent contraction
1. +2 per cent a year
RM100 grows to RM102 in a year. So, if we’re given the choice of having RM100 today or RM100 a year from now, then since a RM100 today can grow to RM102; that is (RM2) better than just receiving RM100 next year. Therefore, money today is worth more than money tomorrow.
2. 0 per cent a year
RM100 does not grow at all; after a year it is still RM100. So, if we’re given the option of having RM100 today or RM100 a year from now, since that RM100 today remains static at RM100 a year later, then that is no better than receiving RM100 next year. Money today is worth the same as money tomorrow.
3. -2 per cent a year
RM100 shrinks to RM98 in a year. If we’re given the choice of having RM100 today or RM100 a year from now, as RM100 today will fall to RM98; that is (RM2) worse than just receiving RM100 next year. Money today is worth less than money tomorrow.
Imagine what would happen if negative rates persist for a decade or two!
Large financial institutions responsible for safeguarding our wealth will be driven to bankruptcy. And regular people (you and I) who rely on POSITIVE bank interest to augment our retirement income will receive no yield. So, we will have to consume capital to survive.
Negative interest rates destroy wealth. They are ludicrous, dangerous and capable of wreaking tremendous permanent value destruction over just a handful of years.
WHAT CAN WE DO
I recommend rejecting ALL negative interest rate offerings that might come our way.
How? By taking advantage of the wealth building positive interest rates we still enjoy in Malaysia, for instance, and in other positive yielding jurisdictions, for ALL our cash deposits, our bond coupons, our attractive dividend-yielding stocks, and our distribution-generating funds that utilise such great savings and investment vehicles. And by NEVER being unwise enough to accept negative yielding ‘investments’ within our future portfolios.
© 2019 Rajen Devadason
Rajen Devadason, CFP, is a Licensed Financial Planner, professional speaker and author. Read his free articles at www.FreeCoolArticles.com; he may be connected with on LinkedIn at www.linkedin.com/in/rajendevadason, or via [email protected] You may follow him on Twitter @RajenDevadason.