Bank note, REalyse

REalyse’s Founder, Gavriel Merkado, considers the important assumption of all things being equal in relation to interest rates. In this article, he contemplates economic history, the relationship between central banks and treasury department as well as how negative interest rates impact market risk.

Read time: 12 minutes

Q: How many economists does it take to screw in a lightbulb? A: 23. One to screw it in, and 22 to hold everything else constant.

It’s quite a dry joke, but I like it.

Ceteris paribus: the concept of holding everything else constant. That’s the impossibility of economics! It’s like trying to study the movements of a single fish in the ocean in isolation to the rest of the shoal or the ocean itself.

One thing that has long since puzzled me in this world is interest rates and their effect on the rest of the world around us. I’ve pondered everything from the relationship between interest rates and life expectancy (negatively correlated) to interest rates and market volatility (not quite sure yet!).

At the moment, I find the idea of a negative interest rate and what that means for the rest of the market perplexing.

An interest rate, in my view, is a rate of return that the borrower pays to the lender, in agreement between the two respective parties. The rate itself is set by the lender, who takes into account the risk that the borrower might be unable to pay the loan back.

For example:

Scenario 1: Payday loan taken out on a weekend at 3am: 1000% interest

Scenario 2: Secured loan against a property to a 20+ year career accountant: 2%

The same works for countries:

Scenario 1: Loan to a country with high political and economic risk: 19.75% (Turkey)

Scenario 2: Loan to a country with lots of oil that has never defaulted: 1% (Norway)

Risk Free Rate

In order to make the maths work for many financial calculations, the concept of a ‘risk-free rate’ was created. And to keep those calculations spinning, it has largely been decided that this is the 3 month interest rate on the debt of the country of interest, if that country is highly rated. Or, if considered globally, the US 3 Month T-Bill is often favoured.


The risk-free rate is the absolute minimum rate of interest that is required from investors just to take the action of making an investment. Anything else in the market should have a higher return than that based on its level of risk. This risk-free rate supports concepts like the security market line, CAPM model, Black-Scholes-Merton and all kinds of other calculations.

Realistically there is no such thing as a risk-free rate; nothing lasts forever and just because you’re only lending money for 3 months to a government, does not necessarily mean that you’ll certainly get it back. However, many components of financial maths fall apart without it, so it is commonly accepted.

Central Banks and Treasury Departments

(2) - FRED

One other thing to consider before we get started: central banks and the treasury of a country are usually separate bodies altogether. The treasury department is the financial arm of its respective government. It receives loans and claims taxes to fund priorities set by the government. The central bank, on the other hand, holds deposits and is responsible for creating and contracting money supply, as well as setting interest rates.

There is usually very little difference between the rates set by the central bank and those of government debt. Were it otherwise, it would imply that people trusted one organisation more than the other. You can see in the chart above the history of the difference between the 3 Month Treasury Bill (i.e.: the treasury department) and the Federal Funds Rate (the central bank).

There are definitely situations where a big gap can be seen between the two parties, which is typically negative. This indicates that the interest rate offered by the central bank was higher than that of the US Government, implying that people trusted the government more than the central bank in these instances. This makes sense: the government could change the law, march in some troops and shut down the bank – in theory at least. This is unlikely to happen the other way around, or at least a central bank led coup d’état would be a first! Doing so would send a pretty shocking signal to the market and bond prices would likely collapse.

A Brief History of Interest Rates

Prior to central banking, interest rates were set by the market. Individuals would judge the risk of the bank they were depositing (lending) their money with and then decide whether the interest rate they were receiving was appropriate. If the individual thought the bank was not so great, then they would want a higher interest rate for depositing their money. This all makes sense: the higher the risk, the greater the potential reward.

At different points throughout history in different countries, and often off the back of some questionable motives, central banks were created and sustained. In fact, they have a racier and more scandalous history than might first appear to the 21st century mind. The first central bank of France was created by Napolean (who also made himself and his family shareholders) to help rebuild France and to support his military campaigns. The Bank of England was founded to fund ongoing wars with France. The National Bank Act in the US was established by the Union Government to fund the Civil War and later replaced by the The Federal Reserve Act, which was voted into law on 23 December 1913, after a third of the US Senate had gone home for the holidays.

The benefit of their creations being that they had the support of the state without being under the control of politicians, which allowed them to act as central counterparties and lenders of last resort.

So, if in a country the interest rate offered by the central bank is 10%, then pretty much everything else in the economy is going to need to be returning more than 10%. If not, what’s the point of investing in something that is very likely to have a higher risk of default than the government, only to achieve a lower rate of return?

Similarly, because commercial banks borrow from and deposit with the central bank, loans offered by those banks will have to be at a higher rate than the government’s interest in order for them to have a profit margin.

Negative Interest Rates

At first glance, you might think that negative interest rates would not have much of an impact beyond just lowering the overall interest rate in the economy. It just means that the risk-free rate is lower, and so the required rate of return on everything else is also reduced. In turn, it is cheaper for people and organisations to borrow money and that means it is expensive for banks to store deposits with the central bank and so they will be more likely to lend instead.

So, what happens with a negative interest rate? A negative interest rate indicates that anyone borrowing will be paid to borrow, and anyone lending will have to pay to lend. So in addition to the risk of not getting your money back as a lender, you have the certainty of ending up with less money than you started with, even if the borrower pays you back. This doesn’t make any sense.

Imagine for a second what the state of a world in which negative interest rates naturally existed.

The perception of risk in any other investment would have to be so high that you think the safest thing you can do with your money is to give it to someone, who will then charge you to look after it and give it back to you in a few years, minus their fees. This is diamonds in a safety deposit box, cash under the mattress, tins of food and ammunition territory. It implies that there is nothing else out there that can give you a risk adjusted return above zero.

Ouch. The world then becomes an environment of capital preservation, making the least risky choice the only option.

However, this is not what has happened. Because the negative interest rates are not naturally occurring; they have instead been created by the relationship between central banks and the treasury departments of governments. Governments that ‘recently’ discovered that if no one else was willing to lend them money, they could just print more and lend it to each other at extremely low, or even negative, interest rates.

Seems legit.

The theory of low or negative rates is that the low interest rate in conjunction with looser monetary policy (print more money, make credit easily available and so on) stimulates economic activity and results in real growth, which then allows the central bank to increase interest rates again in the future.

But, if left for too long, people are pushed towards riskier and riskier assets, not towards safer and safer assets.

‘The current -0.4 percent negative ECB deposit rate applied to more than €1,900 billion in banks’ excess liquidity implies a €7.6 billion direct annual cost to those banks that hold the excess liquidity…..the direct marginal negative effect of negative interest rates might induce banks to invest in risky projects.’ – Excess Liquidity and Bank Lending Risks in the Euro Area – ECB Paper, 2018

Risk/Return Preferences

What I think is happening as a result of negative interest rates is a distinct shift in the securities market line, characterised by two different personality types in the market:

Return Maximisers
Risk Minimisers

(3) - FIGURE 1

In a ‘normal’ functioning market, I believe there is a ‘natural rate of return’ and a ‘natural risk’ level, much like there is considered to be a ‘natural rate of unemployment’. This could be the long run growth rate of GDP, for example, accounting for recessionary periods. This level is marked by the intersection of the orange and green lines in lines in Figure 1, detailed below.

In this scenario, the natural return of 5% I’ve borrowed from Thomas Pickety and the Natural Risk level I’ve roughly averaged annual default rates data from S&P. The SML (security market line) shows a position where investors should be indifferent to investment choices. Such investors will have a preference for anything above the line (higher expected return relative to risk) and will avoid anything below the line (lower expected return relative to risk).

What seems to happen is that people have set expectations of returns and risk built up over time.

Market participants set their expectations of risk and return from the long run ‘natural’ position. Think of how many people are still unpleasantly surprised to find that annuity payments, savings returns or other pension payments are now much lower than they have been historically, and so look for ‘higher’ returns that match their expectations.

As the ‘risk-free’ rate is lowered, the entire SML shifts downwards, which makes certain investments comparatively more attractive, even if they have the same level of risk as they did before when they were not attractive. This is shown by the ‘negative rate SML’ gradient and the ‘High Risk 1’ marker in Figure 1.

As more money flows to those riskier assets in order to chase returns and match expectations, the returns on those assets fall. This causes the SML line to pivot downwards, which causes investors to chase ever riskier projects and assets. This is shown by the Negative Rate – Risk Factor SML line. To maintain the same level of return as was the ‘natural rate’ the investor has to take significantly more risk.


In real estate, this is often seen through cycles of development and investment that start off in the Tier-1 cities. Then, as the investment returns dwindle due to crowding, investments into riskier Tier-2 and Tier-3 cities begin to occur, where there is often less liquidity and lower quality.

And the same change can be seen across markets.

(6) – BBB

From ever-larger investments into the illiquid and complex world of venture capital (for which I am grateful!).

To ever-lower yields on BBB rated bonds, even if they have the same risk today as they did ten or twenty years ago, competitive demand for anything with a return pushes prices higher and the returns lower.

The Risk Minimisers

Looking again at Figure 1. There is the question of what happens to risk averse profiles, or low return assets in the presence of a negative risk free rate.

Theoretically we know that all investors should be running away from the negative interest rate and out into the market. However, this doesn’t stack up with what is actually happening on central bank balance sheets, particularly in Europe and Japan.

(6+7) image

Organisations and banks are still piling money and assets into the custody of the ECB, even if it costs them to do it. Below is a chart of the ECB’s balance sheet (Assets – left, Liabilities – Right). Bear in mind that for a bank, assets and liabilities are the reverse of corporates, a loan for a bank is an asset; a deposit is a liability.

The largest amount of assets (purple area, left chart) comes from Euro denominated securities. The largest increase in liabilities (blue area, right chart) comes from Euro area banks.

There are some technical reasons why banks and other organisations would want to keep money with the central bank, which are to do with clearing and providing collateral to gain access to reserves. The capital requirements of Basel regulations also come into play. However, the cost of doing so, which in the case of German banks accounts for a 23.8% cost on their profits, is significant. Why would any organisation do that, unless they perceived the other investable alternatives not to be worth the risk?

(3) - FIGURE 1

The juxtaposition of banks lending more and more to riskier projects, while at the same time paying to store cash does not make sense. These are opposite reactions to the same action.

Here is Figure 1 again. The areas A and B, I think, represent what has happened to the low risk / low return section of the market. This is where banks previously might have invested deposits.

In the presence of negative interest rates, banks and other organisations have simply decided that it is not worth the marginal gain in return for the increased risk of losses at the low end of the market, and so have simply decided to ‘take the hit’ and deposit funds with the central bank. Better to have a 100% chance of losing 0.5% than a 1% chance of losing 100%.

As other assets inflate in price due to the low rates and looser monetary policy and returns continue to shrink due to crowding, the amount of money allocated to the ‘take the hit’ bucket increases, as shown by area A expanding to include area B. The losses incurred on those deposits then push the bank to simultaneously deploy more capital into higher risk/return assets to offset those losses, thus pivoting the SML further and further, beyond what is shown in the chart below. If correct, this divergence presents a significant challenge to policy makers, central banks and the market overall.

Wrapping It Up

In 2015, the US Federal Reserve started to raise interest rates. Since doing so, the amount of deposits that it holds on behalf of other institutions has declined considerably. At the same time, the stock market has continued to rise, possibly since that money has returned to the market as the rates return to a more natural level.

Conversely, in Europe stock markets are roughly in the same position today as they were 5 years ago, while the deposits held by the ECB have skyrocketed. This seems counterintuitive until you take into consideration that it is the real perception of risk, which is driving decision-making in spite of the distortion of negative interest rates.

The market risks are actually far higher than the interest rates are signaling, and negative rates are causing a split in the continuity of the market between risk averse and return maximising capital. While it was not the intention of this investigation to recommend any policies, it seems that Europe might actually be better served by allowing rates to come back towards a more natural level and so encourage risk averse capital to come back into the market.

The Russell 3000 Index

(9) - FED DEPS

Deposits held by the Federal Reserve

(10) - DAX

Compare this to the Xetra Dax, which isn’t far off where it was 5 years ago.


Meanwhile, the deposits from European banks increase.

(12) – EUR BANKS

Related Posts