ZIRP stands for zero interest rate policy. NIRP stands for negative interest rate policy. As governments and corporations are awash in debt, ZIRP and NIRP appear to have been embraced whole-heartedly by central banks.
As the federal reserve started to lower its benchmark interest rate back towards zero (it is zero as of this writing), I started to think about what this means for fixed-income investments if they decide to go from ZIRP to NIRP.
In some of the online forum discussions, folks said a drop of 0.5% in interest, e.g. from +0.25% to -0.25% is the same as, e.g., a drop from +0.5% to 0%. To show that this is not really accurate, I presented the following example.
Lets say to have $x to invest at an interest rate of r% for a length of time t. Then as t goes to infinity:
Proponents of ZIRP/NIRP argue that the pros outweigh the cons.
As the federal reserve started to lower its benchmark interest rate back towards zero (it is zero as of this writing), I started to think about what this means for fixed-income investments if they decide to go from ZIRP to NIRP.
In some of the online forum discussions, folks said a drop of 0.5% in interest, e.g. from +0.25% to -0.25% is the same as, e.g., a drop from +0.5% to 0%. To show that this is not really accurate, I presented the following example.
Lets say to have $x to invest at an interest rate of r% for a length of time t. Then as t goes to infinity:
- if r > 0, then the balance, x goes to infinity.
- if r = 0, then the balance stays exactly the same at x.
- if r < 0, then the balance x goes to 0.
In other words, with a negative interest rate, one's balance starts reducing over time and eventually goes to zero. I hope we (the US) don't get to NIRP, but with the economy the way it is, there's no telling. Japan and the EU have been in NIRP for a while now. Large corporations have benefited from this. LVMH for example had an offering of negative yielding bonds to finance its purchase of Tiffany & Co.--a case of investors actually paying LVMH to borrow their money!
The downsides of ZIRP and NIRP
Some of the down sides of ZIRP and NIRP are:
- It penalizes savers and those that depend on interest for fixed income.
- It causes people with money to speculate on assets such as stocks and real-estate.
- It causes real-estate prices to rise so houses are out of reach of the middle class without taking on excessive debt and becoming house poor. This also means that any extended dip in house prices and employment can stress banks as their loans go bad. This is what happened during the housing crisis.
- It forces pension funds to speculate in stocks in order to meet their obligations. This means that any extended dip in stocks will cause a number of these pension funds to become insolvent, putting their ability to pay out pensions at a risk.
- It leads to rampant financial engineering by companies where they take on long term debt to buy back their own stock enriching their stockholders and executives.
- It exacerbates wealth inequality in society since people that are wealthy to begin with (e.g. private equity, hedge funds, large businesses) have access to cheap money that retail investors and small businesses do not.
Proponents of ZIRP/NIRP argue that the pros outweigh the cons.
How to invest in a ZIRP/NIRP environment?
This is hard question to answer and I'm not really qualified to do it, but here are some of my thoughts.
Simple investment in savings and CDs are not likely to yield much. I'm not a big fan of "yield chasing" where you open an account with an online bank only to have them reduce their rates a few months later. Typical yields in a ZIRP environments are close to zero, lower than 0.1%. That amounts to an annual return of less than $1000 on each $100,000 invested. And then there's typically taxes that need to be paid even on those measly returns!
Simple investment in savings and CDs are not likely to yield much. I'm not a big fan of "yield chasing" where you open an account with an online bank only to have them reduce their rates a few months later. Typical yields in a ZIRP environments are close to zero, lower than 0.1%. That amounts to an annual return of less than $1000 on each $100,000 invested. And then there's typically taxes that need to be paid even on those measly returns!
I don't like the idea of being forced to invest in stocks especially since there's an ethical dilemma where I don't want to support the kinds of financial activity that is destroying people's lives. I know stocks will go up (don't fight the fed, as they say), but still.
Gold is an option, but one has to be careful of the pitfalls of investing in various types of gold and the possibility of price manipulation.
Treasury products such as I Bonds and EE Bonds are a possibility but you have to create and manage an account with treasurydirect.gov and some folks have reported less than desirable experiences when needing any kind of customer support. The products also aren't as liquid--minimum holding period, interest penalty if cashed within a certain time period, etc., and there are annual limits on the amount that an individual can buy each calendar year -- $10K of each as of this writing.
Treasury products such as I Bonds and EE Bonds are a possibility but you have to create and manage an account with treasurydirect.gov and some folks have reported less than desirable experiences when needing any kind of customer support. The products also aren't as liquid--minimum holding period, interest penalty if cashed within a certain time period, etc., and there are annual limits on the amount that an individual can buy each calendar year -- $10K of each as of this writing.
If I figure something out, I will update this post.
In the meantime, this is what the chair of federal reserve thinks savers should do. It just amazes me that the chair of the federal reserve and many politicians equate a 401(k) with risk assets. It doesn't have to be that way. Most 401(k)'s offer a stable value fund or money market fund as an investment option. Those 401(k) savers are not benefitting from the federal reserve's policies.
Update 06/27/2020
The fed made a statement saying they will keep rates near zero until at least 2022.
In the meantime, this is what the chair of federal reserve thinks savers should do. It just amazes me that the chair of the federal reserve and many politicians equate a 401(k) with risk assets. It doesn't have to be that way. Most 401(k)'s offer a stable value fund or money market fund as an investment option. Those 401(k) savers are not benefitting from the federal reserve's policies.
Update 06/27/2020
The fed made a statement saying they will keep rates near zero until at least 2022.
