A Bridge Too Far
by: Eric Parnell, CFA
- Negative interest rates seemed at first like a great plan to monetary policy leaders.

- Paying debtors for borrowing money from lenders – what could possibly go wrong?

- It turns out quite a lot.

"It began to seem that the generals had got us into something they had no business doing"
--Cornelius Ryan, A Bridge Too Far, 1974
It seemed at first like a great plan to monetary policy leaders. Global economic growth remains sluggish, but our ability to provide stimulus through lower interest rates is constrained by the lower bound of zero interest rates. Why not then simply break down this barrier and push interest rates into negative territory? Paying debtors for borrowing money from lenders - what could possibly go wrong? It turns out quite a lot. For not only are monetary policy makers increasingly discovering unintended consequences for their misguided actions, they have also now painted themselves into a very tight corner from which it now may be difficult to escape.

Misguided Generals
Remember when capital markets were free to rationally price assets on their own without massive policy intervention? Those were the days. But in the years since the financial crisis, unchecked monetary policy makers at the major central banks have grossly overstepped their bounds with repeated extraordinary and previously untested actions that have made a complete and total hash of financial markets by badly distorting asset prices beyond all recognition.
As a result, these select few masters of the universe have created an entirely new and arguably much greater dilemma versus what they were first confronted with the financial crisis a decade ago (remember the collapse of Long Term Capital Management back in 1998? It seems so quaint now in retrospect, doesn't it?). The plethora of untested and flailing yet extraordinary aggressive monetary policy responses have simply not worked in reigniting global economic growth in any sustainable way. And in some cases, the policies solutions they have pursued have made economic conditions measurably worse, not better. Yet now they are left with the dilemma of trying to extract themselves from previously enacted failed policies while not creating even more disruptions in the process.

Such is the looming end game of gross and excessive monetary policy experimentation for global financial markets. It has never been a question of if, but when. And the final end may bring with it a hard landing in China (NYSEARCA:FXI), the dissolution of the European Monetary Union (BATS:EZU) and an extended period of pain for overly inflated global asset prices including the seemingly unbreakable S&P 500 Index (NYSEARCA:SPY) for which there is apparently no alternative, at least for now that is.
A Bridge Too Far
Take negative interest rates in this context of global monetary policy makers grossly overstepping their bounds. In a common refrain heard by the markets throughout the post crisis period, central bankers proclaimed in so many words "it may not help all that much, but it doesn't hurt to give it a try". It is a paraphrase that has driven me endlessly mad during the post crisis period, for it ignores the likelihood for unforeseen consequences, particularly given the fact that such policy measures have been previously untested. And here we are today dealing with as much.
So what is the issue? Sure, on the surface the idea of negative interest rates would seem to encourage increased lending activity. Viewed at its most elementary level, if savers are being charged to keep their money in the bank, they will be all the more motivated to spend, thus fueling economic growth.
And if interest rates are negative, debtors will be all the more inclined to borrow even more, with at least some of this money moving into spending and productive capital expenditures to support economic expansion. What could possibly go wrong? A lot, it turns out.
First, negative interest rates have created an environment where it is now difficult for banks to make money. Sure, low interest rates may encourage debtors to want to borrow more, but if banks can't make any money on the deal with net interest margins getting squeezed, it all of a sudden becomes difficult for these lenders to prosperously operate. The banks can simply lower deposit rates, the central banker might say? Sure, but it is tough for a bank to lower its deposit rate below 0%. For once you start deflating the value of your customer savings by charging them to deposit money, the more likely these customers become to withdraw their money from the bank and either hold their money in cash or seek out alternatives that might provide a flat to incrementally positive yield instead. Taking this one step further, any such mass departure of deposits out of banks (or creeping "bank runs" when put more bluntly) constrains the liquidity that central bankers are so badly trying to promote. At the same time, reduced bank profitability results in falling stock prices that can subsequently test the capital structure of these financial institutions if prices start falling far enough. One has to look no further than many of the leading banks in Europe (NASDAQ:EUFN) and Japan (NYSEARCA:DXJF) to see the direct consequences of such a difficult operating backdrop brought on by negative interest rates.

OK. Negative interest rates are not working. It turns out that it is suffocating the banking institutions that reside at the heart of the global financial system (remember Lehman Brothers?
Thankfully, the systemic risk in the global financial system is less concentrated today than it was a decade ago, except of course the exact opposite is true. Once again, thanks global central bankers. Thanks for that.). So all that needs to happen is the primary perpetrators of this misguided policy - the European Central Bank and the Bank of Japan - simply need to raise interest rates back to the zero bound and end the program.
Ah, but if only it was that easy. The problem with this solution is the following. Now that they have crossed the proverbial Rubicon, it is difficult to go back without negative consequences.
For example, raising interest rates from negative territory back to zero percent involves just that - raising interest rates. And as we all know, raising interest rates, even if it is incrementally particularly around the zero bound, represents a tightening of monetary policy. And given that the European and Japanese economies are hanging on by their fingernails at this point, the last thing these economies need is a sudden tightening of the policy screws. Moreover, the associated implications on the now massive $14 trillion market of negative yielding bonds worldwide would also be decidedly negative, with any associated rise in interest rates adding further to a tightening in monetary policy at a time when it cannot be afforded.
Put simply, these central banks and their underlying financial institutions are now trapped. They cannot loosen monetary policy by lowering interest rates any further, because they will steal even more oxygen from their already gasping financial institutions. And they cannot tighten monetary policy by raising interest rates back to the zero bound either, as it risks sending their economies into recession and sparking calamity in asset prices.
As a result, they are effectively stuck. Can they continue to purchase more assets and pursue even more collateral damaging policies like targeting long-term government bond yields in the meantime? Sure, but these policies will do no better than they already have over the past decade and counting.
Bottom Line
Major central banks have gone a bridge too far. While their creativity to try something new and unprecedented should never be questioned, we are increasingly approaching the end game of the decade-long monetary policy assault over financial markets. And the subsequent fallout effects once the fighting is finally forced to stop is likely to be ugly.
The implications for global financial markets as we proceed toward this end game is likely to become increasingly profound. Global stock markets outside of the S&P 500 Index have been struggling for a few years now, with many markets across the developed world (NYSEARCA:EFA) having already fallen into bear market territory. Thus, the riskier and more cyclical the assets, the more exposed they may eventually be to extreme downside. This is particularly true for those categories that are priced at historically high premiums such as U.S. stocks, high yield bonds (NYSEARCA:HYG) and emerging market debt (NYSEARCA:EMB).
And a bond (NYSEARCA:BWX) bubble of epic proportions has also been created in the process, the unwinding of which is not likely to be a pretty sight.
Ironically, the bonds that so many stock investors have scorned over the years in U.S. Treasuries (NYSEARCA:TLT) may actually serve as a harbor of safety during such an unwind. The same safe haven status may hold true for gold (NYSEARCA:GLD) and silver (NYSEARCA:SLV), the global alternative reserve currencies that stand among the only assets that have not been artificially inflated beyond all recognition in recent years despite the endlessly flowing spigot of liquidity from global central banks. If these safe havens do hold up as expected, they are likely to endure extended periods of volatility in their own right.
Of course, the $100 trillion dollar question behind all of this is not a question of if but when. Any such central banker induced unwind may not get underway for another few years or more.
Then again, it may already be well underway and we simply do not know it yet (this, of course, is how so many end up trapped in the jaws of a nasty bear market).

Does this mean investors should panic and scurry to their bunkers to strategize how they are going to bribe the border guard? Of course not. Investors have already endured two major unwinds in the U.S. stock market since the turn of the millennium and we'll endure the next one too. And once it is over we will likely be left with a three times in a century buying opportunity for long-term buy and hold investors. Such a major market cleanse is not something to dread, but to anticípate.
But investors cannot afford to be complacent along the way. Stay long U.S. stocks, but recognize that many are now running long past their expiration date. Stay long bonds, but watch your credit risk and spreads closely and be ready to transition to safety if and when necessary. And recognize that an allocation to cash can be an asset and not a liability for a long-term investment strategy. For just as investors are hurt by holding cash when stocks are soaring higher by double-digits, investors are rewarded for holding cash when stocks are plunging by double-digits. I for one always love taking advantage of a good sale.
So in summary, stay long, but stay alert. Central banks have already traveled a bridge too far with their latest monetary policy antics. And some meaningful strategic changes may be necessary once the fighting finally stops.