Deltec Flash Note From ZIRP to NIRO | Page 7

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Ultra low or negative interest rates create significant problems for large institutional investors who either have cash flow obligations and/or mandates to match future liabilities. As rates move down the holdings of income generating assets must rise, funded by declining holdings of equities, for example. We have seen plenty of evidence of this already with huge flows out of equities into bonds over the last decade; falling rates precludes any reversal of this trend. The other solution for these institutional investors is increasing the risk profile of their income generating assets to generate the required return. The narrowing of high yield spreads and the rise of covenant lite bonds offers further insights into the effects of declining rates.

Banks must hold reserves against their assets (the loans on their books.) If these reserves are offering negative returns, their cost of funding goes up and the incentive to lend falls. This is why the ECB has tiered the access to their marginal lending facility in the Eurozone, effectively subsiding bank reserves. This does not go far enough to incentivize lending when negative rates are used to buy long dated assets, thereby flattening the interest rate curve. Falling interest rates lead to NIM (Net Interest Margin) compression, explaining why bank shares fall with falling rates.

OTHER EFFECTS

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Finally, negative rates effectively stuffs cash into mattresses. If you lose money by depositing cash at the bank, it pays to hoard the cash at home or in safe deposit boxes. This has the effect of reducing the velocity of money as less is recycled through the financial system.

Falling interest rates have facilitated the growth of corporate debt, have driven financial assets to new highs and can offer governments near limitless spending power as austerity ends; but negative interest rates imperil the financial system, can cramp household spending and distort the balance of risk and reward for investors. We think the risks of negative rates outweigh the benefits, but we expect this experiment will ramp up nonetheless. Both ZIRP and NIRP have profound effects on asset prices. By owning both duration and Gold, we are positioned to benefit.