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When the Model Breaks Down

November 18, 2019

The next bizarre chapter in our unfolding economic saga could be negative interest rates.

 

I’ve warned of negative interest rates policies (NIRPs) before. Today, negative rates are permeating global bond markets.  If our own Federal Reserve employs a NIRP in the U.S., things could get crazy.

 

Despite saying there would be a pause during last month’s quarter-point rate cut, the Fed is still dropping hints it might cut rates further.

 

Meanwhile, the yield on long-term bonds hit a record low last month. The U.S. government sold $16 billion worth of 30-year bonds at a rate of 2.71 percent.

 

The bond market is a barometer for inflation and economic growth. So, when rates hit economic lows, it’s a bad sign – especially when we’re supposedly recovering.

 

There’s a clear signal from the bond market. Will we listen?

 

A NIRP would be damaging because negative rates would adversely affect any industry that earns a profit from positive interest rate spreads. That includes banks, brokerage firms, insurance companies and more.

 

In normal times, banks earn a profit by borrowing short and lending long. They borrow money at low short-term rates and lend it to customers at higher rates, pocketing the difference as a profit.

 

Public brokerage firms do something similar. For example, Charles Schwab earns more than half its revenue from the interest rate spread on idle cash in customer accounts.

 

Why do you think there’s a $0 commission craze? Brokerages need your cash!

 

But if rates go negative, the model breaks down.

 

Firms can’t make money on a spread if there isn’t one. Our system is not meant to handle negative rates. Damage could be widespread, and the losses could be overwhelming.

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