Practical Applications of

Five Mysteries
Surrounding Low and
Negative Interest Rates
It is illegal to make unauthorized copies of this article, forward to an unauthorized user or to post electronically without Publisher permission.

Author: Laurence B. Siegel and Stephen C.

Overview Sexauer
Practical Applications 2018.5.3:1-4. Downloaded from www.iijournals.com by CORNELL UNIVERSITY on 10/30/17.

Source: The Journal of Portfolio Management,

At first glance, Five Mysteries Surrounding Low and Negative Interest Rates,
Spring 2017, Vol. 43, No. 3.
published the Spring 2017 issue of The Journal of Portfolio Management, looks like Report Written By: Kathryn Saklatvala
an overview of current academic thinking on low-to-negative nominal interest rates, Keywords: Asset Allocation, Growth,
their causes, and their consequences, while debunking current popular wisdom on Inflation, Interest Rates, Investment Strategy,
the same topics. On closer examination, the article also cautions practitioners against Monetarism
taking extreme measures in what may appear to be extreme times, finding that the
so-called “mysteries” of negative rates can mostly be demystified by solid application
of familiar economic theory.

Laurence B. Siegel of the CFA Institute Research Foundation and Stephen C.

Sexauer of the San Diego County Employees Retirement Association urge long-
term investors to take a conservative investment approach to the current climate,
sticking to portfolio management fundamentals and steering clear of expensive
alternative investments that promise high performance in a low-return world.

Practical Applications
• An inflationary firestorm is highly unlikely. Although many commentators have
warned that QE would bring the risk of high inflation, thoughtful analysis using
established economic theory provides a strong basis for an expectation of modest
inflation going forward.
• Low and negative rates do not cause long-term sustainable economic growth,
despite the hopes of the governments that introduce them. Investors should not
spend their risk budgets on financial alchemy in pursuit of returns, but should plan
for a low-return environment and budget accordingly.
• Keep major market distortions in mind. Investors have been forced further out
on the risk spectrum, buying equities and real estate as “fixed income substitutes”
in the hope of achieving the returns they require. This increase in the price of risky
assets lowers their future returns.

Practical Applications Report

In 2010-11, Stephen Sexauer of the San Diego County Employees Retirement
Association and Laurence Siegel of the CFA Institute Research Foundation were
trying to understand the new phenomenon of low and negative nominal interest rates.
Siegel was writing articles warning of the “serious risk” of dramatic inflation and
at the same time, though independently, Sexauer’s team in San Diego was trying to
understand why the market wasn’t forewarning the outcomes that those like Siegel

1  // Practical Applications

Key Definitions
Inflation risk premium
The compensation required by investors
for bearing inflation risk (or, to put it
differently, the insurance premium
It is illegal to make unauthorized copies of this article, forward to an unauthorized user or to post electronically without Publisher permission.
investors charge governments to shoulder
the inflation risk). Even if inflation is not
rising, an increase in the inflation risk
Practical Applications 2018.5.3:1-4. Downloaded from www.iijournals.com by CORNELL UNIVERSITY on 10/30/17.
premium would indicate that the market
expects it to rise over the lifetime of the
relevant investment security.
Monetary Keynesianism
Monetary Keynsianism refers to the use of
monetary policy in addition to, or instead
of, fiscal policy to stimulate or regulate
macroeconomic activity. It is distinct from
monetarism in its advocacy of central
bank activism; instead, monetarists usually
favor stable and predictable growth rates
in the money supply.
M2
M2 is a measure of the money supply
that includes all elements of M1 (cash,
checking deposits) as well as “near
money” such as savings deposits, money
market funds, mutual funds, and other
time deposits. It has expanded less
dramatically than the monetary base,
which are the commercial bank reserves
held in accounts at the central bank plus
the total currency in circulation plus the
currency held by the central bank.
2  // Practical Applications
were predicting, with forward-year inflation numbers showing no signs of a spike.
They ultimately joined forces and their observations appear in Five Mysteries
Surrounding Low and Negative Interest Rates, a new article in the Spring 2017
issue of The Journal of Portfolio Management.
“We started to examine this and found that, when looked at closely, we could find
very reasonable explanations for why inflation wasn’t happening,” says Sexauer. He
recollects that many of his peers in public plans were busily purchasing inflation-
hedging assets – assets which have now left them with a “two or three-year
headache” – while he and his colleagues held back. Siegel, on the other hand, was
trying to come to terms with the fact that he had made a series of bad forecasts.
We were experiencing something that seemed extraordinary – something that no one
had seen before. The default human reaction seems to be that you need an equally
extraordinary response,” notes Sexauer.
“extraordinary
 We were experiencing something that seemed
– something that no one had seen before.
The default human reaction seems to be that you need
”
an equally extraordinary response. 
—Stephen Sexauer
Both Sexauer and Siegel have come to agreement on the reasons why inflation did
not materialize and on the broader causes, consequences, and costs of the low-to-
negative rate environment.
AN UNDERSTANDABLE MISTAKE
One question that has scuppered Siegel and many economists, including those
working at the ECB is: how can quantitative easing fail to have ignited massive
inflation or, at a minimum, driven a large rise in the inflation risk premium? In
offering answers, Sexauer and Siegel draw on the work of Wharton professor Jeremy
Siegel [2014] and University of Chicago economist John Cochrane [2014].
Jeremy Siegel argued that the monetary aggregate that counts for setting the inflation
rate is M2 – cash and checking deposits, savings deposits, and money market
funds – rather than the monetary base. While the latter had exploded, the former
had exhibited more slow and stable growth. Cochrane joins the dots between global
technological changes in the new digital world of money and the Fed’s expanded
balance sheet. The key in his analysis is the introduction of interest payments on
reserves held at the Fed, which tore down the wall between “money” (non-interest-
bearing currency and deposits) and bonds. In this new world, money and bonds are
close substitutes, unlike in classical monetary theory.
“It was an understandable mistake,” says Siegel, thinking back to his earlier analysis
warning of inflationary risks. “I had paid attention in school when Friedman and
 others taught us the relationship between the money supply and the price level. But
the nature of money and the nature of society have changed,” he adds.

CAUSES AND CONSEQUENCES

After debunking the QE-inflation connection, Sexauer and Siegel tackle four other
“mysteries” that have important implications for portfolio management. Are low
rates artificial (caused by central bank policy) or fundamental (caused by supply
and demand for capital)? Do they stimulate economic growth? Do they serve as a
It is illegal to make unauthorized copies of this article, forward to an unauthorized user or to post electronically without Publisher permission.

predictor of low returns for investors? And, crucially, do they constitute financial
repression, by depriving the economy of interest on savings? Further, what are the
costs of this form of financial repression?
Practical Applications 2018.5.3:1-4. Downloaded from www.iijournals.com by CORNELL UNIVERSITY on 10/30/17.

Reviewing relevant literature and theories, Sexauer and Siegel argue that low rates
are more fundamental than artificial, using the research of Rachel and Smith [2015]
to show that, because savings are up and investment is down, interest rates are also
down. Recent dynamics have also overturned the conventional economic theory that
low interest rates will discourage savings. In fact, they encourage savings because
people need more capital to produce the same level of income.

“The prudent approach is to budget for lower growth expectations until the evidence
changes,” says Sexauer. “Given current conditions, growth and returns are going to
be low. I see a lot of investors spending a lot of money on alternative investments
trying to get high returns. That is not a good plan,” he advises.

The low- and negative-rate environment has evidently produced severe costs, most
notably an evident redistribution of capital, with borrowers (and equity investors)
“investors
 I see a lot of
spending a lot
benefiting at the expense of (cash/bond) savers. Meanwhile, the market has undergone
significant distortions with investors forced further out on the risk spectrum, buying
equities and real estate as “fixed income substitutes” in the hope of achieving the returns
of money on alternative they require. For investors, the notion that buoyant equity markets are the product of a
investments trying to potentially reversible distortion may have important consequences.
get high returns. That is
not a good plan. 
—Stephen Sexauer
” THIS TOO SHALL PASS

“When you see something happening that you don’t understand or don’t like, the
natural human instinct is to react strongly to it, to ask who caused it, to make them
stop. But the correct thing to do is to step back and do a more thoughtful analysis of
what has changed in the environment or in the theory,” says Siegel. He and Sexauer
believe that, by “thinking slowly,” as Daniel Kahneman put it, investors can avoid
reacting inappropriately to unfamiliar conditions. “Zero and negative nominal
interest rates are something new under the sun, but we can understand and adjust to
them,” says Siegel.

To order reprints of this report, please contact Dewey Palmieri

at dpalmieri@iijournals.com or 212-224-3675.

The content is made available for your general information and use and is not intended for trading or other specific investment ad-
vice purposes or to address your particular requirements. We do not represent or endorse the accuracy or reliability of any advice,
opinion, statement, or other information provided any user of this publication. Reliance upon any opinion, advice, statement, or
other information shall also be at your own risk. Independent advice should be obtained before making any such decision. Any
arrangements made between you and any third party named in this publication are at your sole risk.

3  // Practical Applications
It is illegal to make unauthorized copies of this article, forward to an unauthorized user or to post electronically without Publisher permission.
Practical Applications 2018.5.3:1-4. Downloaded from www.iijournals.com by CORNELL UNIVERSITY on 10/30/17.
Stephen C. Sexauer
ssexauer@uchicago.edu
Stephen is the chief investment officer
of San Diego County Employees
Retirement Association and oversees
the investment strategy for public and
private investments, the investment
team, and investment consultants. In
addition to the day-to-day operation of
SDCERA’s Investment Division he also
assists the board with determining the
fund’s investment policies, strategy, and
asset allocation. Prior to joining SDCERA
in 2015, he worked at Allianz Global
Investors as chief investment officer,
Multi-Asset of Allianz Global Investors
Solutions, managing over $7 billion in
multi-asset institutional portfolios and
retirement income solutions.
Stephen is the co-author of papers
published in the Financial Analysts
Journal, the Retirement Management
Journal, and The Journal of Retirement.
He graduated from the University of
Illinois with a BS in Economics and from
the University of Chicago with an MBA in
Economics and Finance.
4  // Practical Applications
Laurence B. Siegel
lbsiegel@uchicago.edu
Larry is the Gary P. Brinson director of
research at the CFA Institute Research
Foundation and an independent
consultant. Before 2009 he was director
of research in the investment division of
the Ford Foundation and prior to that he
was one of the founding employees of
Ibbotson Associates.
Larry is on the board and program
committee of the Q Group and the
editorial boards of The Journal of
Portfolio Management and The Journal
of Investing. He has won numerous
writing awards including the Graham and
Dodd award.
He attended the University of Chicago (BA
1975, MBA 1977). Larry works and lives in
Wilmette, Illinois and Del Mar, California.