Graham Osborn Posted May 16, 2016 Share Posted May 16, 2016 I had an interesting thought about the meaning of negative rates this morning while reading about the battle between banks and mortgage holders in Spain. Think of negative rates as like discount retailing with price controls. Buyers and sellers can't choose the price of goods, only whether or not they participate in the market. When prices are high, retailers are looking to sell but consumers are reticent to buy -> low volume. As you lower the price, consumers become more and more eager to buy while retailers can boost efficiency up to a point -> volume goes up. But at some level above zero, retailers can no longer make money relative to costs and investory risk hence their willingness to sell collapses. At some level above zero, volume peaks and starts to decline. When applied to banks, this analogy implies that peak credit actually resides somewhere above zero and below that you enter deleveraging. There is a kinetics to this which is perhaps even more important. If retailers could be induced to sell apples for $0.01 for a period of time but consumers were told the situation would not last, consumers would hoard apples (let's ignore the perishability factor here and think home loans etc). But suppose after an extended period the price control authority decided to reduce prices to $0.005. Would consumers buy even more apples? Maybe, but since they already bought so many at $0.01 they might have limited capacity (eg storage space, desire to eat more apples, etc). This implies that if rates have been very low for very long, lowering rates further may have a limited effect to boost volume even from the consumer standpoint. This matters because credit levels are a reflexive (non static) function. Credit tends to rise or fall rapidly. If credit cannot rise, it might hover but should fall rapidly after not too long. If correct, the theory on the valuation of risk assets relative to high-grade corporate bonds becomes bogus at current levels. Risk assets do not rise to infinite levels, but fall off rapidly as rates continue to fall with limited demand or willingness to lend. Link to comment Share on other sites More sharing options...
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