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Here’s How to Explain Negative Interest Rates to Your Spouse

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By NAPA @ Shutterstock.com

The Fed is pushing on a string. With interest rates so low, the Fed no longer has the pull it once did.

It’s shadow banking that controls the money today as Andy Kessler explains in his excellent WSJ piece “The Fed Can’t See Its Own Shadow.”

“What’s going on with the bond market, especially what the Journal has called ‘the relentless demand for longer-term debt securities’?”

It’s called repurchase agreements, or “repos,” a form of short-term borrowing that today has led to nonbank lenders holding more assets than traditional banks. Today, no thanks to Fed intervention in the markets, there’s a shortage of bonds to use as collateral for the repos, and if you can believe it, of dollars.

Jeffrey Snider of Alhambra Investments explains, “The market knows what’s going on and further knows the Fed doesn’t.”

Part of the Fed’s ignorance, says Snider, is its failure to understand the global nature of the dollar. By buying up so many bonds, the Fed has created a shortage of good collateral. To understand this situation, imagine someone you know has equity built-up on their home. If they have good credit, the bank is eager to lend them money with the house as collateral. But if the bank is eager to lend, and the family has poor credit, the bank will deny the loan, leaving that collateral locked up.

But, in my example, what if most of the houses in your town are already used as collateral and demand continues?

How much is the collateral worth if there’s not enough supply?

The answer is, a lot because with no collateral money is dormant.

And as we’re seeing, collateral is worth using even if interest rates are negative.

In the world of repos, U.S. Treasuries are the collateral of choice. With German bonds and other assets falling in behind.

Repos using U.S. Treasuries or other assets as collateral are how money is multiplied today. Kessler writes:

Why? Because of what Korean economist Hyun Song Shin calls global value chains, in which companies need capital for short periods to hold inventory and fund receivables before selling up the supply chain. This is tricky especially across borders, since China’s central bank needs to keep the yuan in line with the dollar. But when China expends dollars, it reduces its own money supply, since its reserves are in dollars. So China funds a lot of this borrowing through repos, derivatives and swaps, often in rolling 90-day periods, as Mr. Snider notes.

Shortages of long bonds—good collateral—are causing “relentless” demand and therefore lower yields. That’s why German long bonds have negative interest rates: not because losing money is a great investment, but because negative interest is the cost of doing business to get “pristine collateral” to use in repos.

The rush for collateral has driven interest rates on low-risk bonds down into negative territory, to the detriment of the mom and pop investor in the U.S.

One way to help the market today would be for the Fed to reduce its horde of Treasuries and MBS, providing the market with better options for collateral.

Because collateral is right in front of the Fed—it’s on their bloated balance sheet.

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E.J. Smith - Your Survival Guy

E.J. Smith is Founder of YourSurvivalGuy.com, Managing Director at Richard C. Young & Co., Ltd., a Managing Editor of Richardcyoung.com, and Editor-in-Chief of Youngresearch.com. E.J. graduated from Babson College in Wellesley, Massachusetts, with a B.S. in finance and investments. In 1995, E.J. began his investment career at Fidelity Investments in Boston before joining Richard C. Young & Co., Ltd. in 1998. E.J. has trained at Sig Sauer Academy in Epping, NH. His first drum set was a 5-piece Slingerland with Zilldjians. He grew-up worshiping Neil Peart (RIP) of the band Rush, and loves the song Tom Sawyer—the name of his family’s boat, a Grady-White Canyon 306. He grew up in Mattapoisett, MA, an idyllic small town on the water near Cape Cod. He spends time in Newport, RI and Bartlett, NH—both as far away from Wall Street as one could mentally get. The Newport office is on a quiet, tree lined street not far from the harbor and the log cabin in Bartlett, NH, the “Live Free or Die” state, sits on the edge of the White Mountain National Forest. He enjoys spending time in Key West and Paris. Please get in touch with E.J. at ejsmith@yoursurvivalguy.com