The Central Bank Obsession Over Negative Rates

I’ve been rattling my brain trying to figure out why central banks are so obsessed with moving to negative interest rates. No rational smart person can really believe it’s good for the economy or stimulatative. It means you lose money!

Finally, last night i had an epiphany. It was crystal clear why the Fed is preparing for negative rates, and why Europe is already negative, and Japan recently went negative.

Over the past 2 years oil and commodities have plunged more, and faster, than any time since 2007.  But the problem is that now that America has become such a major domestic producer of oil, due to the shale revolution, there is now trillions of dollars of toxic debt, and hundreds of energy and materials companies will soon go bankrupt. Well over a hundred.

In the past year, despite oil prices plunging, producers were somewhat insulated from losses, to a degree, because they had hedges. In other words, they bought futures contracts that allowed them to still sell their oil at above market prices, where they were still making a little profit. Not huge, but enough to continue to repay bank loans and bond debt payments. That’s why we haven’t seen bankruptcies in droves yet. But these hedges are largely expiring now. And over the coming 3-6 months, emergy companies are fully exposed to the catastrophic price of oil. It means they will no longer have the cash flow to make debt payments. It inevitably means lots of bankruptcies. You can take that to the bank.

The price of oil isn’t going up much for a long time, at least another year due to huge over supply in a slowing demand world. Most energy companies can’t last that long. This introduces all kinds of problems for major global banks, due to the exposure of toxic junk bond debt. Furthermore, there is toxic high yield debt in other non-energy, non-material companies also. Lots of it.

Add onto all of that the global selloff in stock markets and all kinds of higher yielding bonds, and you get bank balance sheets under severe stress. The kind of stress that makes central bankers really worry about another crisis. Markets have sold off well over 20% in virtually the entire world, except the US. Trillions of dollars of wealth wiped out.

A 20% decrease across the board in assets owned by banks, or severe loan defaults, or defaults on high junk yield bonds held by banks, is catastrophic. Banks become insolvent. Bankrupt. Another Lehman moment and a redux of 2008 ensues, surely. But worse this time given the breadth of exposure. All global banks likely are at risk, not just a tiny little Wall Street bank formerly called Lehman Brothers.

So this brings me back to why the fed and central banks want to quickly move to negative rates. They have no choice. Not to stimulate economic demand. But to prevent bank balance sheets from becoming complete shit.

When banks lower interest rates, even going further negative, it drives up the value of governent bonds as yields decline. Government bonds are one of the largest core holdings of nearly every major bank. By doing this, the banks can offset the asset losses in virtually everything else (stocks, high yields, bad loans) and get to stay solvent. At least give the illlusion for longer.

The problem is that if central banks move too far negative, it creates real bigger problems. (Aside from not being stimulative to the economy.) When interest rates go deeply negative, banks will be forced to pass this onto depositors – savers like you and me with money in the bank. And when depositors get their monthly statement and realize they are losing actual dollars by allowing the bank to hold their money, they decide to withdraw the money from the bank. This creates an unnatural bank run.

A bank run in any economy is the worst nightmare scenario. Everything collapses. The economy doesn’t just die, it’s violently murdered.

So clearly, this smells of desperation by central bankers. Will it work? Fuck no! But not until they try everything they can think of first. They’re really wedged between a rock and a coming freight train headed straight for the rock. Maybe we should call it a fright train. It would seem more appropriate.