Dec 9, 2019

Jim Bianco on Negative Interest Rates, Low Inflation, and Yield Curve Expansion

The Fed fields much of the blame for low interest rates, but are there other pieces to the puzzle?
David Beckworth Senior Research Fellow , Jim Bianco

Jim Bianco is the president of Bianco Research, a provider of data-driven insights into the global economy and financial markets, and is also a columnist for Bloomberg. Jim has 30-plus years of experience on Wall Street, and he joins the show today to talk about Fed policy, negative interest rates, and inflation. David and Jim also discuss the possibility of extending the yield curve, the Fed’s recent forays into the repo market, and what low interest rates mean for the economy moving forward.

Read the Full Episode Transcript

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to macromusings@mercatus.gmu.edu.

David Beckworth: Welcome to Macro Musings, the podcast series where each week, we pull back the curtain and take a closer look at the important macroeconomic issues of the past, present, and future. I'm your host, David Beckworth of the Mercatus Center. We are glad you've decided to join us.

Beckworth: Our guest today is Jim Bianco. Jim is the president of Bianco Research, a provider of data-driven insights into the global economy and financial markets, and is also a columnist for Bloomberg. Jim has 30-plus years of experience on Wall Street, and joins us today to discuss Fed policy, negative interest rates, and inflation. Jim, welcome to the show.

Jim Bianco: Thanks for having me.

Beckworth: Great to have you on. I've read some of your research notes, your papers on the markets. They've been real fascinating to follow. I'm happy to get you on today to talk about some of the topics you've been covering, including negative interest rates, the way the Fed has been running, repo markets and the like, but before we get into it, I'd love to hear your story. How did you get into becoming a Wall Street analyst and start your own business?

Bianco: It's a good story and I'll try and summarize it in a few minutes. I'm from Chicago and I still live in Chicago, or right now, and I got my bug into the markets through the futures markets. I had some experience when I was in high school going down there and fell in love with the futures markets. So when I went to college, I studied undergrad at Marquette University in Milwaukee. I got a B.S. in Finance and I bounced around looking for a job on Wall Street. In 1987, a friend of mine who was working in the research department at First Boston told me, "There's an opening in the research department." So I sent him my resume, and remember, this is before the internet, you basically mail in your resume-

Beckworth: Right, paper.

Bianco: And then they, yeah, they actually sent me a postcard and said please call us. Like, “Oh wow. I actually got an interview.” So I go to the interview, and they're very blunt with me. Now you've got to remember, I'm going to really date myself for some of the people, it's Wasserstein Perella. This is the height of merger mania in the '80s. "Jim, we called you in for a job interview, but we made a mistake. We didn't really mean to call you in."

Beckworth: Really?

Bianco: "But we called you in." Yeah.

Beckworth: Wow.

Bianco: That's what they told me right up at the front. At the time, I'm 24 years old, 25 years old. You can't insult me. It's like, "Okay, well do I get the interview or not?" “Well, they agreed to interview you. It was with the technical analyst.” And so I go into the interview and they kept telling me, "Don't expect much." And I go into the analyst and I say, "You know, you do technical analysis," I pulled out of my bag, some charts, and I showed him, "I'm into this stuff too." And I used this... There's this guy in Racine, Wisconsin outside of Milwaukee. His name is Tom DeMark and he does this thing called the sequential system, and the analyst looks at me and his jaw almost hits the floor. He goes, "Tom DeMark's my best friend. We use all of his stuff here. When can you start?"

So basically that's how I got the job, and from there I've been on Wall Street doing various things. In 1990, I came back to Chicago. I was the director of research of a small brokerage firm until 1998 called Arbor Research and Trading in suburban Chicago. In 1998, I spun myself off as Bianco Research. Arbor is still to this day one of my marketing agents and one of my primary backers, actually an affiliated company, and so I've been doing what I'm currently doing now for 29 years.

Beckworth: Very interesting. So it's great to have someone like you on the show again. We don't get many real world market participants and you're one of the few that have come on the program, so thanks for joining us.

Bianco: Thank you, and I want to say I'm a big fan of your podcast. I listen to most of them. So you've got me thinking about nominal GDP targeting more-

Beckworth: Great.

Bianco: ... than I've ever thought I would think about it.

Beckworth: Great. That's wonderful to hear. But it's great to hear the other side too, and I'm more of an academic. I'm in the policy world now, but it's great to hear what the market's thinking, so having folks like you on the show I think is very important for our listeners as well. And I want to really get into some of the big issues that we're facing these days, and I want to begin with negative interest rates and you've done some really neat work on interest rates, your charts, your tables are amazing. So why don't we begin by having you summarize the state of the world. Where are we in terms of interest rates? I mean what's been the trend? Where are we heading?

The Global State of Interest Rates

Bianco: Yeah, interest rates are heading lower right now than I'm talking about over the last several years. As of last count, we have about 12 and a half trillion dollars worth of negative interest rates. All of that is basically in continental Europe and in Japan. The vast majority of it is in the Eurozone countries as well, too. The most extreme country in terms of negative interest rates remains to this day: Switzerland. They are still negative all the way out to their 30-year bond. They used to be negative out to their 50-year bond. Most countries right now with the exception of the English speaking countries of Australia, New Zealand, Canada, the United States and the UK, all the rest of them have a policy rate that are negative ... I'm talking about the developed world, not leaving the emerging world in the developing world off the equation.

Now I'm not sure if the Five Eyes has something to do with it, the security arrangement, or that we all speak English, but for some reason those are the only countries that are left that have positive interest rates. So the trend had been lower and I might add, what has surprised people about negative interest rates in the last couple of years is that we have them. It was always a thought that you could do it at the front end of the curve by a little bit. It was not a thought that you could see rates go, in the case of Switzerland, beyond -1 percent. They got to 1.35, I think was their lowest on their two-year… And to have it go all the way out the maturity spectrum, all the way out in early September we even got to the 50-year bond in Switzerland turning negative.

So that has been something that not only policy makers but practitioners like me have had to sit down and say, "Boy, I didn't think this was possible." We always used to joke that there was a floor somewhere out there or as Chairman Powell likes to call it, "an effective lower bound." That effective lower bound no longer  stops at zero or maybe slightly below it. It goes much beyond it right now and that's been kind of the state of the world is kind of getting our arms around this concept of negative rates.

Beckworth: Yeah, it's been fascinating to look at entire yield curves as you mentioned, not just short-term interest rates but entire yield curves. And I remember looking at this I think at the end of August, which I believe is when they reached their low and they've come up a little bit. But I remember looking at the Eurozone's yield curve. They have this little online website where you can go and look at it. I don't have access to the data you have, so you could probably look at it on Bloomberg. But I go online to the ECB's website and they showed I believe out to 30 years, AAA-rated securities, negative. I mean that's just amazing. It's mind blowing. And you mentioned Switzerland still is the case. And one of the points you've raised in your notes is that the U.S. is the last bastion of positive rates. You mentioned some of the other English speaking countries, but is it true that we are the country with the highest yields remaining?

Bianco: Yes. If you look at yields across our yield curve, we are not only the highest rates left in the world, we are far and away the highest rates, especially at the back end of the curve right now. There's only two interest rates in the world right now that are above two percent in the developed world and that is the 30- year U.S. Treasury and the 30-year bond in Italy. The Italian bond, it's very volatile. It was as low as 150 about two months ago, but then that's the nature of the Italian securities market as well, too.

If you look at yields across our yield curve, we are not only the highest rates left in the world, we are far and away the highest rates, especially at the back end of the curve right now. There's only two interest rates in the world right now that are above two percent in the developed world and that is the 30- year U.S. Treasury and the 30-year bond in Italy.

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It's interesting because whenever I go give speeches to talk about interest rates, when I talk to American audiences, “I can't believe how low interest rates are. What's the Fed doing? This is ridiculous that these rates are as low as they are.” That's what you hear from Americans. We do have an office in London and we have an office in Switzerland. When I go over there and I talk to them, their reaction is, "I can't believe... you guys are so lucky that you get to invest with a positive yield." And “I would sell my parents to get a two percent yield like you have. You'll relish it, savor it, that you have all these big fat yields available to you in your country.”

So the perspectives are completely opposite when it comes to what's going on with interest rates. And I do think, mainly we're an American audience here, that a lot of people just don't realize how low and negative they are in the rest of the world right now with their complaining about rates. We'll get into it, but I want to say, get used to it. This is the world we're in. We're not going back the other way.

Beckworth: So across most of the advanced world, the name of the game is preserving capital or minimizing its loss, not actually earning capital?

Bianco: Right. One thing to keep in mind about interest rates is they are a security with a price and there is a total return. I'm being obvious. Because what has happened this year, if you go talk to a pension manager in Continental Europe or an institutional investor or a private bank in Switzerland, and you talk to their bond managers, how's 2019 been for you? "Oh, it's been great because we've had this big drop in interest rates all the way through to negative."

Without getting too much into the ugliness of convexity and duration, the price movements on these securities as you approach zero and go negative, get huge. So their portfolios are returning more than the stock market: 20, 30 percent returns that they've seen. And so it's been a great year for them. Now what happens in 2020 and 2021 when you start the year at negative and start calculating your total returns, then it's going to be about loss management. But that's eat drink and be merry right now because they're having great years. We'll worry about 2020 in about 60 days. That'll be a problem for us in about 60 days, but right now, remember I talked to a lot of portfolio managers, institutional investors, and most of them get paid on a yearly bonus. Everybody's focusing on December 31st, that's when I mark my performance for the year and I get paid on that. Boy, that's about 40 days away and we'll celebrate because I'm having a great year. 2020, we'll worry about that in about three months.

Beckworth: That is fascinating and it's a great point too about total return, but that is fascinating. They're looking forward to this holiday season and maybe one of the last ones with a big bonus check. But I'm going to go back to this point you mentioned about interest rates going down around the world, these different perspectives, and it's something that Americans often take for granted. The positive interest rate world, where the rest of the world has gotten used to that and ask why do we have it? Because as you mentioned, people at your events will blame the Fed. They will blame central banks, but you tell a much more complicated story. There's other factors happening and I'm very sympathetic to this story, but I'd like to hear your take on it.

The Root Causes of Low Interest Rates

Bianco: Yeah, I think central banks are part of the process but not the only process, so let me push them aside for a second. Biggest driver I think of lowering rates is the lack of inflation that... let me give one statistic from the United States. I'm in Chicago, Charlie Evans is the Chicago Fed President and I've heard Charlie Evans talk a lot about the Fed and maybe if we see core… they talk about their two percent target being symmetrical and that they want to run it a little higher or the makeup strategy that they talk about, that maybe we could see core get back to two and a half percent and people listen to that and they nod their head and go, "Okay, okay."

Do you know it's been 28 years since core PCE has hit two and a half percent. And I think a lot of people don't realize how low inflation has been. The vast majority of the developed world has rates under... Headline, I'm going to switch to headline inflation, under two and a half percent. The biggest driver I believe of that low inflation has been the boom in technology. This technological boom has changed business cycles, has been down the back of an information technology boom, which has made the information a lot easier to access and it's a lot easier to understand. Look, anybody who runs a business knows if your business is at all on the internet go ahead and price your product one penny above anybody else's product, you will get no traffic because the search engines will not return you as the lowest cost provider.

The biggest driver I believe of that low inflation has been the boom in technology. This technological boom has changed business cycles, has been down the back of an information technology boom, which has made the information a lot easier to access and it's a lot easier to understand.

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You see this in my business, in the securities business, in the world of ETFs, there's this insane ETF pricing war where everybody undercuts everybody else by one basis point in their fee, and what happens is Vanguard undercuts Fidelity by one basis point and billions of dollars flow into Vanguard because they've cut their fees by one basis point, then Fidelity re-ups and cuts their fee. Billions of dollars flows into them. And it happens throughout Amazon and everything else. It's impossible for you to have an outlier price. So it's compressed all of the prices. It's made everything more efficient because not only is it on my end that I can't overprice my product, but my suppliers’ [end]. If I need to see suppliers, I can go online and I could see I need to get X product for my input. I could see around the world everybody's got it and what price they have it.

It's impossible for you to have an outlier price. So it's compressed all of the prices. It's made everything more efficient because not only is it on my end that I can't overprice my product, but my suppliers’ [end].

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And I could just set it up to just pick me the lowest cost producer and go buy it from them or some criteria like that. So I think we start with we have squashed inflation down. I don't think unless we reverse globalization or have some kind of a breakdown in the world order and I'm talking about like a war or we put up some kind of barriers, that's not going to reverse. That's the biggest thing, I think, that's driving rates down. The next biggest thing after that is demographics. Demographics. We are aging. Right now in the developed world there's over 300 million people that are over the age of 65. I believe something like 40,000 a day in the developed world turn 65. As you age, most investment firms will tell you when you're younger, your portfolio should be more riskier, 80 percent, 90 percent equities.

As you age, you want to reduce the level of equities you have. Increase the level of fixed income investment that you have because it's a safer investment. A bear market for investors is, I like to say, is time. So if we were to have a recession in a bear market, in the stock market and it falls 30 percent, that doesn't mean it's the end of the capitalist system. It means, oh well we're going to run through a cycle and it might be five or seven years before we make a new high. Well, if you're 66 years old, you might only have 15 or 20 years left to live. I don't want to waste half of it waiting for the market to recover to where it was when I was 66 so you invest more and more in fixed income. This insatiable demand for fixed income has been pushing rates down.

This insatiable demand for fixed income has been pushing rates down. So not only do you have low inflation, but around the world, you have almost all interest rates now, negative real yields that they're trading below even those depressed inflation rates right there alone as well, too.

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So not only do you have low inflation, but around the world, you have almost all interest rates now, negative real yields that they're trading below even those depressed inflation rates right there alone as well, too. In fact about the only place you could find a positive real yield after inflation is long-term interest rates in Portugal, Spain and Italy and the 30 year treasury in the US, that's about it. Even that the 10 year treasury, at least at the headline level, is still negative. Those two factors alone, technology, squashing inflation and the demographics goading this insatiable demand for fixed income securities probably has gotten interest rates down around the world to zero to one percent right there. Throw in things like globalization and some of the others and you're probably close to zero on a fair value. Now that you've got that lined up, add in a slowdown in Europe, an inability to get the economy moving in Japan and the need of the central bank to react.

They push it over the finish line and get everything into negative. That's why 10 years ago, 20 years ago, maybe the combination of inflation and demographics might've had the fair value of interest rates at four or five percent. the central bank can't step in and say, "Okay, we'll engineer policies to take what interest rates would be at five down to negative." They can't push it that far, but if all of those other factors get you to practically zero to begin with, then they can get you over the finish line to negative. So are central banks somewhat responsible for negative interest rates? Yeah, maybe. But without them we'd be probably at zero anyway. We wouldn't be at four, or three, or five like a lot of people think. We are in this zero to one percent world. That's why I said earlier, get used to it, this is the world we're in.

So are central banks somewhat responsible for negative interest rates? Yeah, maybe. But without them we'd be probably at zero anyway. We wouldn't be at four, or three, or five like a lot of people think. We are in this zero to one percent world. That's why I said earlier, get used to it, this is the world we're in.

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If we were to ever go back to a five handle or four handle on interest rates, I'm talking about like the 10 year treasury. Again, I want to emphasize, something's got to break. Globalization, trade barriers, a breakdown of the internet, war, all of the above. That's how you wind up getting much higher levels of inflation, much higher risk premiums in markets, much higher interest rates. Without any of that, this is the new world we're in.

Beckworth: Yeah. I think most of our listeners would prefer dealing with low rates than dealing with that world of war or upheaval.

Bianco: Exactly.

Beckworth: So it's a trade-off and I think most of us prefer to deal with low rates. But with that said, what is your outlook? I mean, are these trends persistent? Do we expect them to continue forward and continue to push yields lower?

Bianco: Yeah, I think so. I think that there's no reason to think that the movement towards technology is going to stop anytime soon. In the developed world, just to give you my favorite statistic in the developed world, there's the ratio of mobile phones to population is 1.22. That means we have 122 percent telephones to people. So every person has, on average 1.2 phones right now. That's only going up is what's happening. If we're already at more than one phone already-

Beckworth: Interesting.

Bianco: In the developing world, in the emerging world, that's 0.7, 70 percent of the emerging world has a mobile phone and as we continue to put people on and give them that information, think about what it means for businesses, that they get that information, that they can arbitrage, they no longer... they're transparent now they can no longer price themselves out of line with everything else. They can find the lowest cost suppliers for themselves. Then that brings costs down across the board everywhere. So this is not going to... I don't think that these trends are going to change anytime soon. On the demographic front, according to the UN, if you make it to 65 in a developed country, in reasonable health, your life expectancy is 86.

Which is good for all of us to hear that, you've got to get to 65 and not be problematic, so that means you got another 21 more years to live. That is going to mean that I need to structure my money to last two more decades. And demographically, when are you your richest? The day you retire, because then you start drawing it down. So that insatiable demand by investors to own fixed income securities, to keep those rates at negative real yields isn't going to go away. I might parenthetically add about that insatiable demand for investors, Ben Bernanke's the guy that coined the global savings glut in 2005. Wall Street knew this, and what we were doing in the mid-2000s was we were developing all of these arcane securities based on subprime mortgages, slicing them up in the CDOs and we were selling them to the Swedish pension funds and the rating agencies were assigning triple A's and everybody was all excited.

It's just as safe as a treasury security, but it yields one and a half percent more. And then 2008 happened. We know how that worked out. And I think one of the reasons why we're seeing such low yields is Wall Street's standing there ready to create derivative products that are just as safe as treasuries and give you more yield and I think the investment world is saying, "Yeah, we tried that about 10 or 15 years ago and it didn't work out too well." Thank you very much.

And I think one of the reasons why we're seeing such low yields is Wall Street's standing there ready to create derivative products that are just as safe as treasuries and give you more yield and I think the investment world is saying, "Yeah, we tried that about 10 or 15 years ago and it didn't work out too well." Thank you very much.

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I would rather own a 30 year German bond at minus 10 basis points than take my chance on some other derivative security that I need four PhDs seven times to explain to me. And I'm sure at that point I still don't understand what I'm buying. So that's why I also think that we're also pushing into these plain vanilla fixed income securities and not going off into derivative land like we did 10 or 15 years ago. So yeah, these trends are going to stay and I don't think that they're going to change anytime soon. So the trends are going lower.

And the last thing I'd throw in there is let's talk cyclically. US economy's in 11th year of an expansion. It seems to be motoring along okay. Oh, we can make the case that maybe there's some issues. Maybe there is, there isn't. But if we can agree that the business cycle has not been repealed and that someday that there will be, as Ben Bernanke likes to say, to quote Ben again, "The economy is often murdered and that's how you wind up with a recession." Well, we'll murder it somewhere down the line for whatever reason we murder it. High oil prices is usually the leading cause for that to happen, but we don't have that right now. Then we'll have a typical response to a recession. That's when I think you've got the chance to see negative rates in the US. You don't have it now because we have an economy that's doing fine.

But if you add on the demographics and technology, a recession in a response by a central bank and a response by a marketplace that they go back to zero on the funds rate, like they were from 2009 to 2015 with the yield curve as flat as it is now, we could still see, I think rates make a run at zero at some point on the next downturn whenever that happens to be. So, I don't see the trends changing anytime soon. Sure, we might have a cyclical turn where maybe for the next three, six or nine months, interest rates might, you know, the 10 year treasury might make a run at two or two and a quarter, but I don't see it making a run at three or four or anything like that.

Beckworth: Yeah, and this is a concern that I've been thinking about a lot lately. Some of my recent research is what does the Fed do during the next downturn, the next recession? And as you mentioned, rates will be very low, including 10 years, the long end and the short end. So, it won't have much ammunition both for conventional monetary policy and unconventional monetary policy. So it really leaves one scratching their head as to what the Fed will do during the next downturn. I think it's time to be thinking about these issues before we get to that point.

And some people proposed maybe more systematic fiscal policy in terms of automatic stabilizers. I've had some guests on the show who've argued for some kind of rules-based helicopter drop, but my fear is we're going to come to the next recession that you've just described, and the 10 year treasury will be really, really low, so QE won't be very effective if it were in the past at all. But to the extent that it was effective, it won't be a viable tool. And then the short term rates will be really low, so that's not really a viable tool either because of the effective lower bound. And the Fed won't be doing much in the next recession. That's my big concern.

Bianco: Yeah, I would agree with you and I would also throw in the politics too. And you're seeing more of this out of Europe, QE for the people, as Jeremy Corbyn in the UK likes to say. The next downturn, the demand will not only be that the Fed do something, but it will be, as you've said, something along the lines of a helicopter drop, which is affectionately known as Modern Monetary Theory. And that's going to be something that I think will be very difficult for central bankers too because then you're starting to blur the line between fiscal policy and monetary policy if you're starting to do MMT. I think, if I can opine on this, central banks are getting very close to this line right now when they talk about green bonds and they talk about climate change being introduced into their policy making decisions.

Look, climate change is an absolutely legitimate issue to be worried about and to be concerned about, but it's also a political issue. And if central bankers are going to start saying, "Well, we need this political issue to be in there," then the next political issue then will come up after that. And before you know it, we'll be in full blown Modern Monetary Theory and then the central bank will be as political as Congress if they're not careful about it.

So, you're right, we need to be thinking about the tools because if we don't, that's I fear is where we're going to go. We're going to go right to politicizing all the central banks and they're going to be just print the money so that... and Congressmen will probably, I mean, just to give you an extreme example to get my point across. Nothing would happen. You know, "Gee, Mr. central banker, would you please print the money so that my constituencies could have X, Y, and Z?" We don't want it. That's to me the fear of Modern Monetary Theory. We don't want to go down that road, but that's what I'm afraid of.

Beckworth: I think in my mind it's a broader fear that we don't plan ahead so that that does occur. Right? So if we can set the boundaries, the guardrails before we get there and have to acknowledge that things will be different. The normal tools won't be available, so we need to think broader, but set those guardrails up so that it's not abused. We don't have this politicization of the central bank balance sheet. But with that said, there's a cyclical concern, but there's something else I wanted to touch on, and that's your recent discussion of what negative interest rates mean for the financial system. And you talk about how the financial system is not designed for negative interest rates. So, walk us through that point.

What Do Negative Interest Rates Mean for the Financial System?

Bianco: Yeah, I like to say, I use a metaphor like imagine you were there in the Middle Ages in Florence, Italy in the 13th or 14th century when we developed the fractional banking system. And you put it together. So this is what we'll do. We'll take in one Lira and we'll put 90 cents of it out for loans, maybe buy some securities and we'll put 10 of it into a reserve account. And if you raised your hand at that time and said, "Well, what happens when interest rates go negative under that business model," you would have been told to please leave the room because that doesn't work. No, that doesn't happen. Well, here we are in 2019 and that's exactly what's happened. The business model of a bank is to bring in money and then lend it out at a higher yield, assuming that yield is positive. And if it isn't positive, they wind up losing money. And that's what I think you've seen happen. The numbers out of Europe is negative interest rates cost the European bank somewhere between 7 and 8 billion euros a year right now.

This is why, not surprisingly, if you look at a stock index of European bank stocks, it's at a 30 year low. A stock index of Japanese banks where they've had negative interest rates for a lot longer, is back to 1984 levels. 35 years ago. And why 1984? Because that's when the index started. It's at an all-time low right now. These stocks are trading at 1/10th to 1/20th the values they were trading at 15 years ago because negative interest rates for the financial system does not work. Take a pension plan. A pension plan where you have a certain stream of liabilities and you have some assets and you have a discount rate. Well, if your discount rate is negative and you have a $10 billion stream of liabilities for your pension plan, you might need more than $10 billion of assets to meet that liability. No pension plan in the planet is set up that way. So all the pension plans are underfunded, as well too.

Securities valuation. A lot of things in the derivatives world. There's a fancy term that mathematicians use called asymptotic, that what happens is options pricing and derivatives pricing, as rates approach zero go negative, their fair values go to infinity. Well, we try to compensate for this by tweaking the models or maybe using different assumptions, but what I'm trying to come up with is, what I hear a lot of central bankers talk about is when we have negative rates, it means this for the lender. It means this for the consumer. Yeah, but where does that loan come from? It comes from the financial sector. How does the financial sector create that loan in a negative rate environment? The answer is they create it with a loss and every loan they create causes them a loss or potentially causes them a loss somewhere down the line. And eventually they're going to start changing their business models and they're going to start reducing what they're doing as well too.

So, we need to understand that the financial system is at risk with negative rates. Now, where this conversation most likely comes up is in Europe, and what you hear in Europe… Now remember, the populous movement in Europe is a lot more defined than it is in United States. The quickest way to become an ex-politician in Europe [is to] say, "You know, we're doing something that hurts the banks, negative interest rates. We ought to consider to help them." You'll be an ex-politician in five minutes. So yeah, they probably all know that negative rates hurt banks, but no one wants to lift a finger to do anything about it because it's such a toxic talk topic to go through. So they try to quietly behind the scenes try and fix this problem as well too. My point is, yes, negative interest rates are toxic for the financial system. Fortunately, the global financial system has a big out and that is that the reserve currency of the world, the US, has the highest positive rates. So that's been a big buffer. It enables, there's some of the world like Japan and Europe, to have negative rates.

My point is, yes, negative interest rates are toxic for the financial system. Fortunately, the global financial system has a big out and that is that the reserve currency of the world, the US, has the highest positive rates. So that's been a big buffer.

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But if the US was to wind up going to negative rates, I think that there would be severe stress on the financial system. It's just not set up that way. We could redesign it. We could go to a fully reserve system. There's other things we could do to redesign the financial system, but that would be a wholesale change from what we do. But right now, the way that we've got it now, it won't work if we think that we're going to stay in a permanently negative situation.

Beckworth: That's a very troubling scenario you paint there. Again, as you mentioned earlier, rates are going down even in the US so we might be there sooner than we want. I've seen studies that underscore your argument that banks are struggling in Europe because of negative interest rates. So empirically you've got great support. But let me play devil's advocate here.

Bianco: Can I throw-

Beckworth: Yeah, go ahead.

Bianco: Can I throw one other quick thing [out there] about that? What's also happening in Europe, I mean, talk about how you can't save the bankers. So they go to negative rates in Europe and all accounts in most European banks of over 500,000 Euros will be charged a negative deposit rate. Why? Because if you have 500,000 Euros in the bank, you're not going to take it out and put it in a shoebox under your bed. But if you have 3,000 euros in the bank and they want to charge you a negative interest rate, you might do that. When bankers started talking about the possibility of going to negative rates on deposits all the way down to zero level of deposits, in Germany, their debating bills to make it illegal to have negative deposit rates. So the central bank will charge you minus 50 basis points, but you can't pass that along to your customers. Again, that's because of how toxic the banks are. So we're going to legislate a loss for those banks as well too. So that's another thing that’s been happening.

Beckworth: Bleed them dry. Yeah.

Bianco: Yeah, exactly.

Beckworth: That gets to-

Bianco: You can play devil's advocate.

Beckworth: That gets to this, yeah, it gets to the devil's advocate point I was going to make and you've kind of answered my question already, but academics who make the case for negative rates and some would go beyond that and say abolish physical cash, which would I guess be your common earlier wholesale change the financial system. But some would say, "Okay, keep physical cash, but let's make a clean argument here. What we want to do is lower rates, but we want to lower all rates and preserve the spread." So the model you mentioned earlier for banking, there's this net interest margin.

You fund short term, low cost and then you lend at a higher rate, riskier type asset, right? So you have this spread between your borrowing costs and your lending costs and that net interest margin is how you make your money. So some advocates of negative rates might say, "What we want to do is to lower both of those proportionately so you preserve the spread for the banks and that way they stay in business. So you can have negative rates and successful financial firms." But what you just painted for me is that that doesn't work in practice, that for political reasons, you can't have both of those fall symmetrically.

Bianco: Right. Just remember now, you still need investment. So we're going to legislate so that the yield curve stays positive. It's all negative. But it's still a positive yield curve with all negative rates. Well then that leaves the investor, hey, the bank still needs investors. Why am I going to invest in a bank in that environment as well too? Not only will we have to reinvent the financial system, I will seek other types of investments that are away from this. Where you're starting to see that happen is in the world of gold and in the world of cryptos. The knock on gold for 5,000 years used to be, "Why would you invest in something that doesn't yield anything?" In 2019, gold is the high yield alternative at zero. So that's why you've been seeing more interest in gold and the same thing with cryptos.

If my investment options are zero to negative, well, Bitcoin yields zero. That's a high yield alternative versus everything else. So if you tried to legislate that, you're going to push more and more people into the fringes, into these alternative worlds, and maybe back to the oldest investment, gold, and other things like that. You're going to create whole new classes of investments that don't exist right now. So you still won't accomplish what you're trying to do because by lowering those rates, you're trying to say, "Let's keep the system as is, but let's just tweak the rules so that it works." Really doesn't. You really need to start, you need to come with a whiteboard and say, "Let's start all over. Let's redesign the whole financial system."

Not only will we have to reinvent the financial system, I will seek other types of investments that are away from this. Where you're starting to see that happen is in the world of gold and in the world of cryptos. The knock on gold for 5,000 years used to be, "Why would you invest in something that doesn't yield anything?" In 2019, gold is the high yield alternative at zero. So that's why you've been seeing more interest in gold and the same thing with cryptos. If my investment options are zero to negative, well, Bitcoin yields zero. That's a high yield alternative versus everything else. So if you tried to legislate that, you're going to push more and more people into the fringes, into these alternative worlds, and maybe back to the oldest investment, gold, and other things like that.

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No one wants to do that because no one knows what that is and the people that run the current financial system don't benefit from that because you're going to give them a whole new system that they're unfamiliar with. So that's why I think that this whole negative rate thing is very problematic. Thank God the US has positive, otherwise it would be far worse than it is right now.

Beckworth: Well, Jim, let me take out my white board and play God here and I'll add a little tweak to the US financial system and I want to see your response. So rates are going down, they might even become negative. One thing we can do, and it's been proposed and Secretary of the Treasury, Steve Mnuchin's considered, is just extending the yield curve, issue a 50 year government bond, a 100 year government bond. Those would presumably have positive rates because they're farther out. So what are your thoughts on that and what's prevented the Treasury from doing so?

Extending the Yield Curve

Bianco: Oh, I think that they should be doing it. If I could go wave a wand and put myself in charge, I would say that the new yield curve is 30, 50, 100 and perpetuals and we're going to hold an auction every day until we get all $22 trillion worth of debt refinanced at 30, 50, 100 perpetual. Because I think that it lowers the reinvestment. Take advantage of these low rates. By the way, how low are rates? You're probably be familiar with the Dick Sylla and Sidney Homer book, *A History of Interest Rates*, which tracks them back to 3000 BC. There's the last version of that book in 2005 it's 700 pages in it. There wasn't one reference to negative rates and-

Beckworth: Interesting.

Bianco: So we've got the lowest interest rates ever recorded in human history. Yeah, you better take advantage of that and lower your reinvestment risk because that's one of the biggest risks you have is I get a good yield now, but eventually it matures and then I don't know what I'm going to get on the other side. Well, lock it down for a century, lock it down for half a century and don't worry about it. It's somebody else's problem then at that point, hell, we're all over 65 anyway. So it's going to be somebody else's problem at that point. So yeah, I do think you should be extending those maturities. Why aren't we? Because it's not in Wall Street's interest to do that.

A long-term security is very volatile. It's very difficult to trade. It's very difficult to market. We have the Treasury Auction Borrowing Committee, which is made up of all of the banks and the investment banks that help the Treasury issue the securities to fund the government. They have made it very vocal that they're not in favor of any long-term security. I understand why. It's very difficult for them. Their opinion matters. But they are only one voice. What that TABC, the Treasury Auction Borrowing Committee is missing is an advocate for the taxpayer and the taxpayer advocate, as I would have argued, would have said, "No, we want to push out. We want to take advantage of the lowest interest rates in 5,000 years to reduce that reinvestment risk that we see in the marketplace right now and to go for it."

So I would like to see the Treasury do that. I know that they're starting to talk about the potential of bringing on a 20 year bond, which has been nicknamed the Millennial, and a new 20 year bond that is, and maybe even a 50 year bond at least to move forward from here. But I hope that they do that and it would be the start of more and more of lengthening of the investment. It benefits the taxpayer to do it that way.

Beckworth: Now you mentioned that the holdup are these primary dealers that make up most of the committee that advises Treasury and you've suggested coming up with a system where you can kind of bypass the primary dealers or at least expand the pool of folks who could sell the treasuries for the government. Is that right?

Bianco: Yes. What's happening now with most securities issuance now, is most people probably have this idea in their mind that if I'm a company or government and I have to issue securities, I engage an investment bank and then they call their clients and they pitch the virtues of the security and I have to fill out an SEC document and go through a road show and all that other stuff. Yes, but today we have these electronic platforms that you can put your securities on and the whole world can see. You can bypass this whole dealer community as well.

That is happening in various sectors of the financial markets right now, that they're being bypassed, the dealers and the investment banks are being bypassed and you could go directly to consumers or to investors by publishing your securities. There's dozens of these platforms that are out there right now. The Treasury is still stuck in that pre 1980… that's why they have the Treasury Auction Borrowing Committee in the first place, is to ask their bankers what is the best way to issue this debt.

If the dealer community is afraid of a 100 year bond or a 50 year bond and they don't want to do it, then engage a Bloomberg, or engage one of the other platforms and say, could you help us? When we want to issue the bond, we'll just post it on the platform to tens of thousands if not 100,000 investors around the world. And they can just jiggle their mouse and click, I will buy, I will buy, I will buy, and we'll see what kind of interest we get. What I just said strikes fear in the dealer's heart, because, oh my God, what if it works? They'll do the whole thing like that-

Beckworth: Be out of business.

Bianco: And then I'll be out of business in five minutes, but they also know that that's what's happening to them in every other form of their business as well, too. Part of the technological boom that we've seen in the financial markets.

Beckworth: Okay. For all of our fans who listen from inside the halls of the Treasury building, take note and listen to Jim's advice. And I know there are some of you in there. Why hasn't this change taken place already? I mean you've got Steve Mnuchin, he's from Wall Street, he's Treasury Secretary. Why has the Treasury been stuck on this primary dealer arrangement? Is it something that requires an act of Congress or is it just inertia, vested interests? Why no change?

Issues with Primary Dealer Arrangement

Bianco: I think it's a vested interest and inertia. I think that on balance, the primary dealer community works. We are funding the government. We don't have a crisis with investors buying Treasury debt. The idea of using a platform could save you money, could make it easier, but the word there is, could. There are some examples where it's worked in the municipal bond market and some others, but those are small examples. It's a school district, some suburban school district issued some bonds on one of these platforms and they got bought. Okay, well that's not quite the $22 trillion, $23 trillion US Treasury market. That's a different equation altogether.

I think that on balance, the primary dealer community works. We are funding the government. We don't have a crisis with investors buying Treasury debt. The idea of using a platform could save you money, could make it easier, but the word there is, could. There are some examples where it's worked in the municipal bond market and some others, but those are small examples.

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So there's always a risk that as you move to something like that, it could be a little messy. There could be unforeseen consequences, and in the world of Washington, then somebody gets blamed. So the inertia makes it much easier to do. So I suspect that if we ever do move to it, the last thing that will move to it will be the Treasury market. The private sector will go there first. The private sector will show that it can work directly that way. And then it will have to come to the Treasury. Don't expect them to lead. They'll have to follow.

Beckworth: Okay, well it seems inevitable, right? It's kind of like being a provider of some good, and you refuse to sell your good through Amazon. Everybody else is, but you're the last holdout and you want to do it through the store front. And the store front wants to keep you coming to them. This seems like very antiquated way of doing business in this modern age.

Bianco: Yeah, you even see this in the stock market, they call it direct listings. No longer do you do an IPO where you put together an investment bank and stuff. You just basically call the New York Stock Exchange and say give me a ticker symbol, and okay, starting on Wednesday, here's how many shares I'm going to have available for anybody who wants to buy them. A direct listing, so we're even doing it that way as well too with stocks.

It's only been a handful of issues, Spotify being one of the larger, more high profile examples that has done that. And they come out of the tech world, but it's coming. It's coming like it's coming with everything else the way that technology just changes the way we do business. And when I say changes the way we do business, what does it do? It cuts out the middleman out of everything, and an investment bank and a dealer is a middleman. And they're just being cut out like they've been cut out in retailing and they've been cut out in everything else that we've seen because of technology.

Beckworth: I guess if I were a primary dealer I would be looking at investing in these platforms myself, so I would be able to compete with the future that's coming.

Bianco: Oh, and they are.

Beckworth: They are, okay.

Bianco: They are the biggest investors in these platforms as well too, that people will come to them. If I was to put together a platform company, the first place you go is to dealers, because they know this and that's exactly what they're doing. And they're in the process of changing their business model. If you go walk through the campus of Google and you go walk through the trading floors of Goldman Sachs, you'd be hard to tell them apart, that they've so changed the way that they've done their business right now. Not just Goldman Sachs in particular, but a lot of Wall Street, they operate more and more like tech firms like everybody else does. So they know this and they are definitely changing, but we still have these legacy businesses like the way we issue Treasuries, and they're going to be around for awhile. It's going to be awhile before we see those changes, but I can see that where it will happen someday.

Beckworth: Okay. Let's speak to one other issue that relates to interest rates, yield curves and the like. That is the repo market actions, the money market more generally. You've written about this and most of our listeners are aware of the challenges that have occurred. September, we saw this big spike. Repo rates reached close to 10 percent. These big banks are holding the lion's share of the excess reserves that lent into it. It surprised people. There were stories that were told, that the Federal Reserve had wound down its balance sheet too far, had kind of pushed itself or tripped accidentally back into a corridor system from a floor system and now it's retreating. It's funneling $60 billion a month through Treasury bulk purchases. But you have a very skeptical take on what's happening. So what is your sense of what the Fed is doing and what are the troubles ahead for it?

The Fed and its Repo Market Uneasiness

Bianco: Yeah. I've used the analogy that what's happening in the repo market is when you turn on financial television, “oh, the repo market was a problem in September and it's gone away and it's fixed.” And I said, “Yeah, it's fixed because we've medicated it into submission.” But we have not addressed any kind of a long-term cure any more than you would say an ADHD child is fixed because we pump large quantities of Ritalin into them. That's essentially what we've done to the repo market. It's calm, it's functioning, but it's not a long-term fix to have the Fed providing repo and buying bills. By the way, the combination of those two just surpassed $300 billion. I know Brian Sack's paper got a lot of play in late September when he said the Fed might have to apply up to $250 billion to support for the repo market.

That's essentially what we've done to the repo market. It's calm, it's functioning, but it's not a long-term fix to have the Fed providing repo and buying bills.

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We just zoomed past 300 billion this week and we're not slowing down at all, and we're continuing to go. The Fed not being in the repo market in the United States is now almost 25 percent of the market right now as well. The problem long-term is not all repo was created equally. The idea on a collateralized loan, that's what a repo loan is, right? I have a bunch of government securities and you're my dealer. I give you the government securities, you give me cash. Or we do a reverse repo and go the other way. The problem with that is I don't say, "Oh, I don't care if you default because I've got the securities." The idea is I don't want you to default. I don't want you to go belly up because I don't want to encourage bad behavior by you. So it's a private sector function and there is a credit consideration

At the Fed, there isn't. Either you meet the rules and you get loans, no questions asked, up to a limit. Or you don't meet the rules and you don't get a loan for whatever reason as well too. It's okay for now. But as we go forward from here, I think it will become more and more problematic, especially in a time of stress. In a time of stress when the Fed is engaged in these living wills and trying to worry about systemically important financial institutions and stuff, this could be an encouragement to reckless behavior. If we get to a period of stress, and we're still doing this. Because I can show up at the Fed, hand them all a bunch of securities, get some cash, and then I don't know what you're going to do with it then. I don't want to know what you do with it then.

If you show up at JP Morgan and try to do the same thing, they're going to ask a couple of more questions and make a discrimination about how much they want to give you up to what point, or maybe charge you a premium because you're going to do something riskier with it. So I do think that what they've done is fine for now, but they have not fixed the problem at all, and it seems to be growing as well. What is the problem to go on that? I think we've over-regulated the market. I think that the G-SIB rules and the liquidity coverage ratio rules and the high quality liquid asset rules and Basel III and everything else that we've added onto them, even though the technical calculations say that there's over $1 trillion of excess reserves in the system, you can't use that money. That we're actually probably at, that is unencumbered is more like zero right now.

So I do think that what they've done is fine for now, but they have not fixed the problem at all, and it seems to be growing as well. What is the problem to go on that? I think we've over-regulated the market.

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Problem is when Chairman Powell has been asked, will you back off on the liquidity coverage ratios? He was asked this in his September FOMC presser and stuff. And when they've been repeatedly asked, the answer has been “no, we're not going to back off on these rules. We'll add more reserves.” Add to that that Elizabeth Warren has sent a letter to Steve Mnuchin saying, because Mnuchin said maybe we ought to back off on the rules, she sent a letter to him saying, “No you don't. You're not going to give these bankers a pass.” I'm kind of channeling my inner Warren here. You know you're not going to give these bankers a pass by backing off on the rules. And I'm thinking to myself, oh great. The Fed's already got one president mad at them. Let's start working on getting the next potential president mad at them by backing off on some of the rules.

So if their answer is going to be they're going to be a permanent part of the repo market by supplying reserves, I think this market's going to become problematic over time. Now for the next several months or as long as we don't have any kind of a stress point, it's not an issue. But if they think they're going to stay doing this supplying reserves or having a standing repo facility where they can permanently supply reserves to some point, I think this is going to become a problem. Last thought for you. Why do you think… the Wall Street Journal had a story, no one uses the discount window…

Beckworth: Yep. I saw that.

Bianco: …because there's a stigma attached with the discount window. There's no stigma attached with borrowing from the fed on repo. And eventually you might want to have one, otherwise you wind up having the problems that you had with no stigma on the discount window. Hey, the banks will do every… we'll shoot for the moon, go borrow from the Fed and go for it. And we you don't want them to do that. And that's what I'm afraid we might be headed down. I don't hear any answers from Federal Reserve officials other than them to just say, “Oh, the market's calm.” Well yeah, you've drugged it into submission, that's why it's calm. But you haven't come about saying how you plan on getting out. And I don't think they know at this point.

Beckworth: Well I think there is a middle ground here and I'm not sure how aggressively it's being pursued. I've heard the Fed is considering this, maybe even looking at it. Randy Quarles, for example, has mentioned this possibility. It would make Elizabeth Warren happy but also address some of the concerns that you've raised. And that is you don't change the regulations, but you reinterpret how you apply it in terms of high quality liquid assets. So, do the banks really need to be holding more reserves versus treasury bills? And maybe you could ease some of the strain along that margin.

But one of the ironies I see in all of this, and this is something Bill Nelson who was on the show a few weeks ago, he talked about this issue as well, is the whole point of all these new regulations were to make banks safer. To avoid the repeat of the crisis we had in 2008. And the irony is it may have made them safer but also made them more fragile. They don't know how to respond to these crises. They can't respond to these crises when there's strains in money markets and like you've said, they've become highly dependent upon the Fed. You could become so dependent on the Fed that they're safe, but they're fragile. They're not very robust to shocks that come toward them. So the whole point of the new regulations seems to be kind of undermining itself.

Bianco: Yeah. You're right though about the middle ground, about that you can reinterpret some of the rules to give the bank some leeway. But the problem there is, Randy Quarles, Steve Mnuchin reinterpret the rules. Problem solved. Then Elizabeth Warren wins. She brings in her own treasury secretary.

Beckworth: Good point. That's a fair point.

Bianco: And she brings in her own federal reserve chairman. We just reinterpreted them the other way. And then it seems like every four to eight years these rules will get reinterpreted over and over again. So that's the danger in going down that road as well too.

Beckworth: Fair point. All right, well the time we have left, I want to move on to the Federal Reserve as an institution. We don't have a lot of time, but I want to bring this up because you've written about the Fed’s groupthink. And you wrote an interesting piece that the new nominees might be just what the Fed needs. And interestingly, I learned that you yourself were considered for the Board of Governors. You interviewed at the White House. But tell us about this whole issue of groupthink at the Fed as you see it from the marketplace?

Groupthink at the Fed

Bianco: Yeah. Just on that last point you brought up, I know Larry Kudlow. I've known Larry Kudlow for many years. He invited me into the White House and interviewed me, and he also interviewed a couple of other private sector people as well too. And then they picked Chris Waller and Judy Shelton. And it was a great honor for me to go to the West Wing of the White House and talk to Larry about this kind of position.

But as far as the groupthink goes, I think my interaction with the Fed, I want to break it down two ways. If you get beyond the FOMC board and you get behind the decision makers and the people that the decision makers talk to. So I'm talking about the thousands of other people at the Federal Reserve. There's really not a lot of groupthink. There's a lot of ideas, there's a lot of thought, there's a lot of creativity going on at that level. But when you get to the policymaking level, there seems to be a tremendous amount of groupthink and a tremendous amount of pushing the idea along the line that we have to promote our policies. The groupthink as best summarized is in the last 25 years there's only been one Fed governor that has dissented from any meeting.

But when you get to the policymaking level, there seems to be a tremendous amount of groupthink and a tremendous amount of pushing the idea along the line that we have to promote our policies. The groupthink as best summarized is in the last 25 years there's only been one Fed governor that has dissented from any meeting.

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Beckworth: It's remarkable.

Bianco: It's interestingly that even in a groupthink culture like Japan, they have a lot more dissents in their monetary policy committees than they do with the Federal Reserve, as well too. I think it would behoove them to think more like the Supreme Court. The Supreme Court would vote five [to] four, that's a rule. No one says, “Well it's almost not a rule.” But the Fed somehow thinks that if we have a fully staffed Fed, which we haven't had many years, and you had a seven-five vote on monetary policy, that they're afraid that that sends some kind of a mixed signal to the market. That it was almost not monetary policy and it sows confusion.

I don't think that's a problem at all. If they were to make that point understood and allow for new and different ideas at the policymaking level and push on the policy making level’s ideas. I don't think it helps the Fed when I hear Chairman Powell use that “the economy's in a good place” and that stuff. And then you hear all the governors and everybody else use the same wording that the chairman uses to explain what's going on with the economy. You're not really helping, I don't think, the issue by just parroting. You're allowing one person to make policy. I thought we were supposed to have more of an active idea there.

My point is it's there in the institution down at the lower levels, the medium levels and stuff. they're there, but it doesn't ever make it up to the policymaking committee. I don't think it helps the Fed. I think one of the reasons that they might have missed this repo thing is because they weren't thinking about it in the right way. Maybe if they were, they would have still missed it. Sure. But I think that this is one of the problems that they face. It doesn't help the Central Bank to have this kind of groupthink.

And yeah, if they brought in a Judy Shelton or a Herman Cain or Steve Moore, I know that the Fed people turn their nose up. But if the institution cannot survive a Steve Moore or Judy Shelton as 1 of 12 policy-making voices, then it's got a real problem on its hands. Or even two of those voices. That's because it would be an upset to the groupthink and I don't think it would help them in the long term.

Beckworth: When I think of the groupthink issue, I think of the governors in particular. It seems that they have fallen in line pretty closely with what the chair votes. And I know there's discussion and there's horse trading probably going on behind the scenes, because some of them have responsibilities, overseeing banks and there's other decisions that have to be voted on besides monetary policy. So I'm sure there's some of that going on. But what I find troubling is that you see the biggest dissents from the regional bank presidents.

So, Neel Kashkari, Jim Bullard, [and] now they tend to be voting more in the dovish direction these days. And if you went back 10 years you'd have the regional presidents voting in the more hawkish direction. And so you get, you take the ying with the yang. And maybe you don't agree always with what the regional bank presidents are voting, but you see more push back, more discussion, at least in my view from them than you do from the governors. And I do worry that there's some incentives in place that prevent governors from freely expressing themselves. Again, I'm saying this without being fully informed on what happens on the inside and also acknowledging there's probably politics behind the scenes that I don't know about. But-

Bianco: You know, let me just say that-

Beckworth: Go ahead.

Bianco: ... I agree with you that there is a lot of that horse trading, but I also point out to you that there's been over 700 governor votes in the last 25 years and only one dissent. And that was Mark Olson in October of 2005. Yeah. I don't expect three dissents every meeting. I don't expect a dissent at every meeting. But to have the vote go 699 to 1 over the last quarter century. That's what we're talking about when we talk about-

Beckworth: Something's amuck.

Bianco: Yeah.

Beckworth: Yep, absolutely.

Bianco: Yeah.

Beckworth: Well, with that, our time is up. It's been a great conversation with Jim Bianco. Jim, thank you so much for coming on the show.

Bianco: Thank you. I enjoyed it very much.

Photo by EITAN ABRAMOVICH/AFP via Getty Images

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