April 2015: Welcome to Crazy Town


What would you think about taking a job in which you, the employee, pay your employer to work? That is, you receive a “negative wage.” Wouldn’t you consider that a crazy idea?

Essentially, that’s what European central banks are trying to pull off. If only Samuel Clemens were alive today to see The Adventures of Tom Sawyer come to life in grand fashion! In Europe, as in Crazy Town, the cash reserves deposited in European central banks represent the “employees,” while the negative interest rates received by depositors are the “negative wages.”

That’s right, the European Central Bank (“ECB,” the European Union’s counterpart to the U.S. Federal Reserve Bank) has imposed negative interest rates on excess reserves the commercial banks deposit with the ECB. Independent of the ECB, the central banks of Switzerland, Sweden, and Denmark have also imposed negative interest rates on commercial bank deposits. Yes, the cash reserves deposited by commercial banks at government-run central banks now earn negative interest. Depositors pay for the privilege of money on deposit with the bank!

Here’s how it works:

  • The central banks embark on programs of Quantitative Easing (a fancy phrase for printing money and buying bonds).
  • Newly created money is used to buy bonds.
  • The bondholders deposit the sale proceeds into commercial banks.
  • The intent (hope?) of central bankers is that commercial banks will make loans with their newly received deposits and, in the process, stimulate the economy. (Never mind that there is no evidence that this would actually work!)

But, there aren’t enough credit-worthy borrowers that want to borrow.  So, the cash sits idly and commercial banks return

the cash to central banks as “excess reserves.”  Central banks figure that if they make commercial banks pay for the privilege of depositing funds with their respective central banks—by imposing negative interest rates—it will coerce banks to lend more.  However, it’s not working that way.

There is rich irony in all of this! Central banks created the problem of commercial banks having excess reserves (too much cash). Now, they want to penalize commercial banks for depositing the excess reserves that the central banks created! This is a classic big government scenario—create a problem, and then provide an ill-conceived “solution” to the problem that didn’t exist until they created it!

Logic, Reason, and Prudence are Non-existent in Crazy Town

For centuries economists believed that interest rates could not go lower than zero because no one would deploy capital at a negative rate.  If anyone is still wondering, negative interest rates offer further proof that years of government intervention and excessive money printing have created gross distortions in financial markets. Conventional, rational thinking is suspended, as Europe enters a land of uncharted folly.

Negative Interest Rates Spread to Bonds

The negative interest rate phenomenon has also spread to bonds issued by some of Europe’s stronger, more stable countries. Bonds issued by the Netherlands, Germany, Sweden, Denmark, Switzerland, Austria, and Finland have recently traded at negative yields (negative interest rates). This means that interest payments and repayment of principal at maturity will not recoup the current cost of buying the bond! Investors that buy these bonds and hold them to maturity are guaranteed they will not get all their money back. This is not just some trading anomaly. In late February, Germany issued new five-year bonds with negative interest rates. Welcome to Crazy Town!

If commercial banks are penalized for having too much cash, then depositors at those commercial banks can reasonably expect to also pay for the privilege of depositing money in the bank in the not-too-distant future. In fact, this has already begun in Germany. As of last November, Deutsche Skatbank, founded in 1859, began imposing negative interest rates on large depositors, charging them 0.2% to hold their deposits! Large depositors pay to deposit money at Skatbank.

Why would anyone buy a “negative interest rate” bond?

The primary reason that investors are willing to hold negative interest rate bonds is there are no secure alternatives for their cash. When there are no attractive alternatives, it becomes a matter of “embracing the least-worst alternative.”

The basics of negative interest rates are easy to understand: you get less money back than your initial cash outlay. Therefore, wouldn’t it be preferable to simply hold the cash balances as paper currency instead of having it deposited in a bank? For small investors, that makes sense—currency is preferable to negative interest rates at a bank. However, for banks and other financial institutions, businesses, pension funds, IRAs, and mutual funds, holding currency poses logistical problems such as storage, theft, portability, and meeting regulatory standards. Holding currency is not an option for many depositors.

Investing in Crazy Town

In Crazy Town, there are challenging problems for prudent investors that wish to both protect their capital as well as to generate profits. Ultra-low interest rates have induced many investors to “use up their cash,” swapping their cash for what they hoped would be investments with higher returns.  

However, when one investor uses their cash to buy another investor’s stock or bond or real estate, the cash isn’t actually used up, it merely changes hands. As more cash was pumped into the financial system —$4.5 trillion created in the U.S. from 2010-2014— the game of cash chasing investments accelerated, pushing the prices of investments higher and higher. All of that cash needed to find a home but could never be “used up.”

Five years of printing money and near-zero interest rates have created distortions so great that prices for stocks and bonds seem to no longer matter! There has been a disconnect; there is seemingly no link between price and worth. In Normal Town, prices matter. Would you buy something without regard to the price? Can you imagine Warren Buffett buying a company regardless of price? Absurd!

But, in Crazy Town people do because, well… “investing” doesn’t need to be rational or make sense or be consistent with any measure of prudence. In Crazy Town people act as though the link between price and worth is no longer relevant. That helps explain why today’s stock market is the third most overvalued market of the past 130 years, exceeding all prior valuation peaks except 1929 and the late 1990’s—and we know how those ended.

Crazy Town is like a movie set, a temporary place, a flim-flam sham. At some point, the participants will suffer the consequences of their wanton behavior, similar to those caught up in the late-1990’s tech bubble aftermath. Regret will sink in and they will ask themselves, “What was I thinking?”

For us, seeing the activities over in Crazy Town doesn’t mean we, prudent investors, need to join in, abandoning logic, reason, or prudence. To the contrary, seeing the madness is a loud call to investors to vigilantly abide by their disciplines and endeavor, more than ever, to protect capital.

Normal Town operates with a more conventional framework: governments don’t recklessly distort financial markets, interest rates are positive, prices matter, and capitalism rewards deferred gratification.

The best course for investors is to restrain from joining the foolishness in Crazy Town. Instead, we have positioned your and our portfolios conservatively and prudently, emphasizing capital preservation while maintaining ample cash reserves and bond reserves—reserves that can be deployed when prices become normal and the potential for high profits returns. Maintaining a straight path while others veer requires patience and discipline. It may not be easy, but patience and discipline will reward its adherents well. ***

Greg Schultz & Bruce Grenke


Addendum:  Traveling deeper into Crazy town!                                                                                                                                                    On April 7, 2015, the Swiss government issued new ten year bonds with negative interest rates of -0.055%.  Buyers of these bonds have just entered a contract to lose money for ten years! Crazy!


© Asset Allocation Advisors, Inc. 2015