Making Sense of Negative Interest Rates

By DrugsandFIRE | Seeking FI | 13 Apr 2020

On March 25th, 2020, yields on US debt traded negative for the first time in our country's history.  With the 1 month and 3 month T-bills trading at yields of around -0.05% and -0.03% respectively, the US officially joined the negative interest rate club.  But what does that mean?

And, perhaps more importantly, how the hell does something like this happen?

At face value, the concept of negative interest rates seems absurd.  Who in their right mind would lend money for any amount of time given the promise of getting less back in return?  The proverbial "mattress" has a better return on investment than such a loan.  So why would bonds, which are purchased on the basis of yield, find a buyer at a negative rate?  It just doesn't make any sense.

Or does it?  To try and explain what's going on, let's first talk about something somewhat unrelated to interest rates: oil.

The Extremes of Supply and Demand

If the coronavirus wasn't enough of an economic shock for the world, turns out the world's major oil producers (OPEC+) decided that now was a great time to get into a price war!  Now, without getting too far into the weeds on this, basically the members of OPEC+ decided to drive down the price of oil by creating a surplus.  However, with the coronavirus effectively shutting down travel and substantially reducing the demand for oil, the price of oil gets hit from both the supply and demand sides.  Nothing new there.

But, here's the thing.  Supply can't just build indefinitely.  Oil needs to be stored somehow and storage capacity isn't infinite.  Taken together, the forces of supply and demand coupled with the fact that the oil producers can't store any more of the crap lead to the situation outlined in this article where the price of oil itself might've gone negative! 

Basically if there's no demand for what you have and you need to offload it, you might have to pay someone to take it off your hands. 

You know, like trash.

And, as it turns out, a similar thing happens with money.  But to understand that, let's talk about banks for a sec.

Banks and the Price of Money

What is a bank?  The way most people understand it, a bank is simply a place where people can store their money and get loans.  But that description doesn't tell us much when trying to figure out negative interest rates.  No.  To help us do that, let's simplify things and look at banks as if they're just another type of store you'd go to.  If you want to buy some clothes, you'd go to a clothing store or, if you wanted to by some tools, you'd go to a hardware store.  But what if you want to buy some money?  If you want that, you go to a bank.

When you want to buy some money (assuming the bank's willing to sell it to you) that money has a cost just like any other good or service.  The only difference with money is that you don't pay for it up front, you pay for it over time in the form of interest.  Therefore, and this is really important, interest is simply the "price" of money

That pricing then works both ways.  If you want the bank's money, you can take out a loan and pay the bank interest; and if you have money that the bank wants, you can deposit it and get paid interest yourself. 

But what if the demand for lending drops and thus, the demand for deposits?  In that case, you might not get paid for your deposit at all.  Taken another step further, what if the bank is so flush with cash that it doesn't really have much capacity to take on more?  In that case, you might have to pay the bank for the convenience of storing your money.  In effect, your deposit would carry a negative interest rate.

But that doesn't explain negative yielding bonds does it?  Ah, but it does.

How We Get to Negative Rates

Turns out, banks (and other entities with a lot of cash) need a convenient place to store their money too and here in the US, that storage takes place by and large in the US treasury market.  Treasuries serve two vital functions for the whole financial system.

  • A safe store of value (treasuries carry no risk to principle)
  • Liquidity (they're easy and cheap to move around)

So if you've got a ton of cash, want a safe place to park that cash, but don't want to pay to store/transport physical bills yourself, you buy yourself some US treasuries!  In particular, you buy ones with a short duration (less than 1 year maturity) that you can use essentially as a cash equivalent.

In a crisis though (like the one we have now) where cash is king and safety of principle is the name of the game, what happens?  Market participants sell their risk assets such as stocks in exchange for cash, there becomes an excess demand for storing cash but a scarcity of places to store it (there are only so many treasuries), and the price of these bonds get driven up causing their yields to drop.

Now there's nothing new there.  That sequence of events repeats nearly every time we have some sort of event triggering a market crash.  What is new though is the Fed engaging in a process called quantitative easing (QE).  In QE, the central bank injects cash into the financial system by directly buying treasuries (and other securities) off the books of banks.  By doing this, the Fed hopes that given their excess cash positions, banks are given incentive to lend.

Unfortunately for the Fed (and other central banks for that matter), general economic trends going back to the Global Financial Crisis have created an environment where banks are much more reluctant to lend.  For many banks, lending money when lending rates are kept low and poor economics brings credit risk into the equation isn't a great deal.  What results, is a decrease in the velocity of money; aka the demand for cash.  And as it stands, that demand is the lowest it's been in over 60 years.



So if we have a monetary situation where cash is abundant, there's a limited supply of safe things to store it, and there's really no demand for it, what happens? 

You pay to store it.

You get negative interest rates.

Thanks for reading



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I'm a pharmacist pursuing financial independence, hence drugs and FIRE.

Seeking FI
Seeking FI

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