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Why Interest Rates Will Asymptotically Approach Zero Forever (Part 2 – Specifics)

Why Interest Rates Will Asymptotically Approach Zero Forever (Part 2 – Specifics)

by Srikant Krishna (sri@srikantkrishna.com )

In the previous post we had set the stage after the largest credit (read: debt) expansion bubble in the history of the world. Affluence truly seemed both eternal and contagious, changing lives and the standard of living around the globe. Central banks aberrantly contemplated that they firmly had control of interest rates, and through it the price of time, and in transitive sequence, a general manipulative mechanism on economic growth.

But in reality, they were absurdly incorrect. The global financial crisis has at its roots many causes, but the capability can be assigned to two very basic human characteristics: incompetence and greed. Whereas politicians all over the world were making promises that could simply not be funded, primary dealers of bonds were more than happy to comply by funding deficits across many developed nations. And central bankers, ostensibly a component of the incestuous revolving door apparatus that conjoins politics, academia, policy institutions, central banking and investment banking, suffered from exceptionally pathological delusional incompetence.

As individuals, corporations, and finally governments attained the economic analog of the Malthusian carrying capacity in terms of debt and the ability to service it, the global credit and financing systems began to collapse, and with it, a massive indiscriminate delevering across the board produced what is known as the Global Financial Crisis. After all, a debt based monetary system requires both the principal and interest to be repaid – or in another words, a perpetually exponential growth in the issuance of credit. If, by whatever reason, endogenous (war, depression) or exogenous (natural disaster), the credit issuance mechanism were to be retarded, the funds required to pay the interest component of debt service would not be available (and perhaps neither the principal), and the entire system deflates back to reality through an endless series of defaults.

During this period, U.S. Treasurys attained extremely low yields, and remained that way for the subsequent years. Investors felt the safest instruments to park their assets were U.S. Treasurys, backed by the full faith and credit of thousands of nuclear warheads, hundreds of foreign bases, and a very aggressive and cogent policy, driving the yields down on these instruments. Additionally, coordinated central bank action across the globe resulted in massive backstopping of otherwise insolvent financial institutions through a combination of mechanisms including asset purchases, repos, and lowering of both the EFF and discount window rates in the United States and their equivalents abroad.

Europe, however, was beginning to fall apart at the periphery (even though the core itself has been rotting for quite some time now). Some modicum of recovery seemed to finally occur in the summer of 2009, but this was short lived until precisely the Greek chaos that ensued in the spring and summer of 2010. The situation continued into 2011, with the collateral damage including the ablation of MF Global and “rumors” of pending calamity at Jeffries. It was the ascendancy of Mario Draghi to the throne as the head of the ECB, and an extraordinarily determined European bureaucracy that finally compressed PIGS yield spreads from an inevitable fiscal collapse. But I hear that a substantial portion of the populace is burning freshly cut forest wood for warmth this winter…

The purpose of this pair of articles is explain why interest rates will remain low forever, and asymptotically reach zero (and a concomitant negative real yield). There are three required factors that would elicit, sustain, and promote this phenomenon indefinitely in the absence of popular and social abrogation: the mathematics of bond yields, the unsustainability of fiscal provisions, and the intervention of central banks. Let us now explore in detail each of these requirements and contributing factors to the zero interest rate environment that has become the new normal.

From a basic mathematical perspective, with the intuition and practice that can be attained in grade or high school, we can understand that the yield on a bond instrument can be represented as k/x, where k represents the original payments in the interest service, and x is the price of the bond. Visually, as the price of the bond increases, a plot of the yield versus the price becomes extraordinary flat. Mathematically, as the price of the bond (x) increases to very high levels, the derivative, or rate of change, of this function (-k/x^2), approaches zero. The largest rates of change of yield with respect to price is when the price of the bond is very low. This is one of the reasons why in the summer of 2011, yields in peripheral European countries were exploding. However, once the price of the bond is forced to be sufficiently high, either by endogenous market participants (funds), or exogenous factors (central bank intervention), it is exceptionally difficult to influence the yield based on the simple aforementioned relationship. Therefore, it only required that the ECB, BoJ and the FED push bond prices to a certain level whence it becomes absurdly facile to maintain low rates.

Secondly, if bond yields were to increase, many so-called “developed” economies would become insolvent overnight. The cost to service the debt would far exceed the income generated by taxation revenue for these sovereigns. Personally, I believe that the central banking system frankly does not commend this sort of fiscal subterfuge and immorality, but is forced to participate in the suppression of rates for purely political purposes. Let us be honest, and state that central banks today are far less “independent” than they insist, and are increasingly branches of fiscally insolvent (read: inept) governments. After all, when presented with the scenario of a standing army of soldiers and domestic police demanding promised benefits, versus a small group of highly educated gentry in suits, my expectations of the superiority of enforced subjugation certainly lie with the former group. Yields cannot increase without corresponding widespread social chaos, and therefore will be suppressed by an increasingly politicized banking system.

The final reason that bond rates, will in perpetuity, remain low for “certain developed nations” has to do with the practical basis underpinning fiat currency. This topic has been well discussed both in the real world and the ethereal internet, so I will neither profess any particular bias nor explanation. But in the context of examination of factual evidence, given the previous two reasons, all that is required for central bankers (or primary dealers and equivalents) to retain or suppress interest rates is to simply to act as marginal buyers. It is purely this simple. Given the mathematical relationship between yield and prices, and the political incentive, nay charter, that is extended to certain financial institutions, all that is required is a slight excess of demand (buyers) over supply (sellers) to forever maintain the low interest rate requirements. But unlike hedge funds, retail investors, sovereign wealth funds, and even investment banks, the singular capacity afforded to those “privileged” nations with a central banking system will ensure that bids can be conjured from the void, and digital funds are transmitted within femtoseconds, immediately leaping into the commodities and “risky” asset markets. Good luck with your USD $6 chai latte.

As the real economies across the globe continue to decline, and the indulgent promises afforded during the extravagent years come to fruition, it is the confluence of these three powerful characteristics that will ensure that yields remain low. Until of course, social or natural phenomena disrupt the engrained charter than has not been sapiently decided, but rather forced, upon swaths of the world.

Copyright © 2013, Srikant Krishna

Srikant Krishna is a financial technologist and quantitative trader. He has a background in biophysics, software development, and the capital markets.

You can follow him on Twitter @SrikantKrishna, and on LinkedIn at http://www.linkedin.com/in/srikantkrishna/, or e-mail him at sri@srikantkrishna.com.

You can visit his blog as well.

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Why Interest Rates Will Asymptotically Approach Zero Forever (Part 1, Background)

There has been much discussion and chattering in the financial and mainstream media regarding the possibility that interest rates may increase because of reduced action by th FED. Across the Atlantic, investors have been mystified how countries experiencing upwards of 50% youth unemployment can retain low sovereign debt yields simply due to the actions of a one Mr. Draghi. Across the Pacific, a large number of investors will shortly lose their shirts betting on higher JGB yields.

Low interest rates are a necessary and predictable consequence of the massive credit-fueled bubble conceived on August 15th, 1973 when the dollar was no longer constrained by a gold standard, even on an international basis. Since that era, the wizardry, nay sophistry, that is finance has allowed credit (a more polite expression of debt) to be created at an unprecedented rate. But the miracle of finance relies on one fundamental principle: debt is borrowing the future. So, relatively quickly individuals began to finance their vehicles over several years, students accrued student debt to be paid back over their lifetimes, and households suddenly began to procure homes through 30-year loans. This is the essence of credit: the borrower trades their future production for current consumption.

The availability of cheap credit elicited an enormous growth in asset prices across the board during the past forty years. Wall Street fared the best, with a stock market that seemingly was to return 8% or more in perpetuity. In fact, many annuity policies and pension plans were structured on this flawed assumption. In prior decades, stocks an bonds were reserved for the affluent. The tremendous growth in the availability of credit, in combination with the inception of the IRA, drew a large swath of the population into investments in financial instruments that they never would otherwise done. The money instead would have saved at the local bank, which would have lent to the local community businesses and so forth. Instead, the sudden infusion of cash flowed straight into the so-called money center banks, which then proceeded to use the proceeds to engage in more sophisticated casino games known as derivatives and structured products.

But just as both individuals and corporations were prone to very fundamental long-term errors due to the availability of easy credit, governments also fell prey to deceptively simple borrowing. Balanced budgets became an extinct creature, and slowly but surely, Washington, Tokyo, Madrid, and corresponding state and local governments expanded in size and scope. Furthermore, pension plans for government workers were established based on defined-benefit pink-unicorn 8% per annum asset growth projections. Cheap credit enabled the West, which had extremely efficient credit generation and distribution systems in place, to eventually win the Cold War against a system in which borrowing the future was no simple task, and one that would have been regarded as mystical to not-well-connected.

And the cracks were starting show early onwards. The constant pressure imposed by leverage and borrowing began to take its toll in the 1990s, with issues such as wage arbitrage and NAFTA being the explosive economic choices that corporations and countries had to grapple with. After all, when the bills started coming in, the only way the maintain an identical lifestyle was to reduce costs. And so foreign manufacturing and services quickly began to transform the workforces of so-called developed economies into systems that relied on the exchange of capital rather the production or real goods or services. Simon Johnson, in his May 2009 article in The Atlantic, “The Quiet Coup” summarizes this process in great detail and with an excellent use of the English language.

It was a singular and revolutionary innovation that postponed the end of the debt bubble and produced real and measurable economic growth: the Internet. This technological revolution extended the “good years” for another decade, until the early 2000s. But there was a problem with the new era ushered in by this advancement: it made global wage and price arbitrage much easier to accomplish. Whereby before computer code may have had to been transmitted by satellite using proprietary protocols, fiber optics and ethernet changed the picture. An order for factory goods no longer required faxes or snail mail. It became trivial to communicate with anyone, anywhere, anytime around the globe.

And there lies the basis of the dilemma. In a world where everyone is on near equal footing, how can there be justification for one country or region to afford a better lifestyle than any other? The short answer is that there is none, and Generation X, Y and the millennials are feeling the impact of not having to compete with the two hundred students in a high school graduating class, but rather two hundred million students from around the world of the same age who are a simple air flight away from attending the same university or obtaining the same job.

So, against this painful backdrop for developed economies, the crows are suddenly coming home in droves to roost. In the second part of this article, I will describe in detail why it follows that interest rates will remain low forever.

Copyright © 2013, Srikant Krishna

Srikant Krishna is a financial technologist and quantitative trader. He has a background in biophysics, software development, and the capital markets. He grew up in Holmdel, New Jersey, New York City, Boston, and currently resides in Stamford, CT

You can follow him on Twitter @SrikantKrishna, and on LinkedIn at http://www.linkedin.com/in/srikantkrishna/, or e-mail him at sri@srikantkrishna.com.