Negative interest rates have become entrenched

by Michael Collins, Investment Commentator at Fidelity

March 2016

Capitalism’s essential difference from a planned economy is that it allows the price mechanism, rather than some central authority, to allocate resources. Capitalism’s pricing system is facing a test that economic theorists who discerned the circular relationship between price, demand and supply never imagined. This trial is the entrenchment of negative interest rates or, to put it another way, a sub-zero price on money.

The spectre of long-lasting nominal negative rates solidified on February 11 when Sweden’s central Riksbank surprised investors by cutting its key cash rate from minus 0.35% to minus 0.5%, in a bid to achieve its 2% target for inflation. The move came a year after the Riksbank invented the concept of negative cash rates and seven years after it pioneered rates below zero on bank deposits held at a central bank.

The Riksbank’s shift occurred only 13 days after the Bank of Japan shocked investors by adopting a rate of minus 0.1% for some deposits, to fight off the deflationary forces unleashed by China’s slowdown and the collapse in oil prices.

The Bank of Japan’s decision lifted to five the number of central banks offering negative cash or deposit rates; the others are Denmark’s Nationalbank (a deposit rate of minus 0.65%), the European Central Bank (a deposit rate at minus 0.3%) and the Swiss National Bank (a deposit rate of minus 0.75% and a target for three-month LIBOR of between minus 1.25% and minus 0.25%).

Negative central-bank rates have led to nominal negative yields on money and bond markets. Within 11 days of the Bank of Japan announcement and nine days before it came into effect, the yield on the Japanese 10-year government bond turned negative, to mark the first time that investors have been prepared to lose money to hold the 10-year sovereign paper of a G7 country. On March 1, Tokyo sold bonds with a negative yield for the first time, meaning investors paid for the privilege to lend money to Japan’s government. On the same day, 11 European countries including France, Germany and the Netherlands had negative government bond yields, usually out to five-year bonds though out to 10 years for Switzerland. The countries with negative sovereign yields cover about a quarter of the world’s output.

A torpid economic outlook for the deflation-ridden eurozone and Japan flags that interest rates could go even more negative. The Federal Reserve has said it would consider the policy option, if circumstances warranted. Investors are right to be concerned. Policymakers have embarked on an experiment that involves a political choice in favour of governments over savers. The benefits of negative interest rates are unproven, even dubious. Many warn that perverting the price of money encourages financial risk-taking that will only postpone and magnify another financial upheaval. They caution of unintended consequences, especially within the banking system and to central-bank credibility. These warnings cannot be dismissed.

It must be said, though, that negative rates have prevailed on global bond markets for over a year and they have caused no disasters yet. The negative rates seem too small to matter. They are yet to apply to bank deposit rates in a widespread or drastic way. Sub-zero rates appear almost the perfect antidote for a debt-burdened world. Repayments drop and governments are paid to implement Keynesian stimulus. There is a limit to how low interest rates can go because people can simply hold cash instead of depositing it at a bank. Surely, that means any threat posed by rates below zero is contained. It’s real interest rates that count, anyway, not nominal ones. And real rates were far more negative in the 1970s than they are today. But negative rates are little help to a debt-ridden world because they are a by-product of deflation, which boosts real debt levels. There is no limit to how widespread sub-zero rates could become, nor any constraint on how long they could persist. It’s yet to be shown sub-zero rates can revive economies by creating demand. Of significance, negative interest rates show that central banks are out of politically acceptable options to stir economies.

Pros and cons

Cutting interest rates to below zero is supposed to stimulate an economy and engender inflation, just as any other rate reduction would. Lower rates encourage businesses to invest and consumers to spend. At the same time, they prompt banks to lend rather than keep reserves, a supply-side tonic. They put downward pressure on a currency, which should help exporters and drive up inflation expectations. The prospect of faster inflation can unlock consumer spending by making people think they‘d better buy before prices rise. Loose monetary policy usually boosts asset prices, and thereby encourages people to feel wealthier. Time will tell if these attributes come into play. The problem is that when economic growth is feeble few businesses and consumers want to borrow. Sub-zero rates can dent consumer confidence, if people think that central banks are panicked. That can prompt people to save more, as appears to be occurring in Japan.[1] Negative or low interest rates reduce the income of those who live off their savings. They could prompt banks to lend recklessly.

Give the downward pressure they theoretically put on currencies, a common condemnation of negative rates is that central banks are engaged in a currency war; a zero-sum game of undermining their currencies to boost exports. There are three aspects to this claim that point to it being overblown. It is the main motive in Denmark where the krone is pegged to the euro and no doubt in Switzerland where officials worry about a surging franc, but the other three central banks are mainly aiming to boost inflation. Currencies, via their influence on import prices, are just one aspect of the inflation outlook. Secondly, central banks know that interest-rate differentials have haphazard influences on exchange rate. This was once again shown by how the yen rallied more than 6% against the US dollar over the 18 days between the Bank of Japan’s announcement on negative rates to its implementation. Negative rates are little drag on the currencies of the eurozone and the other four countries at sub-zero because they post current-account surpluses, generally the most important fundamental driving exchange rates. Denmark’s current-account surplus was at 7.0% of GDP in 2015, the eurozone’s at 3.2%, Japan’s at 3.0%, Sweden’s at 6.7% and Switzerland’s at 7.2%, according to IMF data.[2] Lastly, a currency war is not the same as a damaging trade war, as many imply. In a trade war, everyone but the protected industry is worse off. In a currency war, at least central banks are loosening monetary policy. That, in theory, should help spur their economies and thereby demand for imports, which is the opposite of a beggar-thy-neighbour policy of the 1930s’ trade wars.

While the world is not facing trade-war-like damage from negative rates, the Bank for International Settlements has warned of unintended consequences that low or negative interest rates could portend. Firstly, the bank that acts for central banks said, negative rates reduce pressure on governments to control their debts levels by lowering yields and by flattering debt-service ratios. Another problem is they take pressure off politicians to implement unpopular microeconomic reforms that could boost productivity. Thirdly, they distort market valuations and boost the risk of a sudden loss of confidence. The fourth problem is they disrupt the business models of financial institutions. Lastly, they risk denting the public’s confidence in the ability of central banks to revive the economy.[3]

A side-effect to watch

The greatest menace that negative interest rates appear to pose is to the financial sector, especially the bedrock banking system. The retail-banking business model is to attract money from savers by offering an interest rate and then to lend the money out again at a higher rate. What will happen if people lose money by leaving it with banks? In theory, if it’s safe to do so, they will hoard cash. The concern is that banks will need to still offer people a positive nominal savings rate to attract deposits and so will be forced to narrow their lending or profit margins. Another way to look at the threat to banks is that negative interest rates exacerbate the inherent riskiness of banking; that bank assets are long-term loans while their liabilities are short-term deposits.

The threat to bank profitability – or ultimately their viability – resulted in bank stocks falling to close to twice the extent of the broader market during the recent turbulence on global stock markets.[4] Of extra concern is that negative rates are being implemented at a time when banks are being disrupted by innovative ways to connect savers and borrowers and they are facing populist anger over their role in the 2008 upheaval. Sub-zero rates especially place at risk insurance companies whose business model is to sell products with guaranteed returns. They are a menace to pension funds with fixed long-term obligations.

As usual these days, the biggest threat is to Europe where the banking system is fragile. Eurozone authorities have failed to tackle the bad debts on bank balance sheets. Efforts to build a proper banking union have stalled if not collapsed because three of the four pillars needed for a successful banking union are either half-baked or missing. There is no common deposit guarantee, no proper bank recapitalisation fund and a defective backstop in place to rescue failing banks but this is a single regulator. Negative interest rates thus threaten the business model of Europe’s save-and-lend banks that form the bulk of the financial system. European insurers are under scrutiny because it’s estimated that two-thirds of life-insurance policies in the EU offer some type of guarantee.[5]

Another threat from sub-zero rates is the opposite consequences to the warnings given by the Bank of International Settlements when it said it could stop governments controlling their debts. This risk is that politicians avoid expanding their fiscal deficits to revive demand, for fear of incurring the displeasure of the forces arrayed against government use of debt. Many would argue that central banks are forced into desperate policies such as sub-zero rates because politicians have been too timid on fiscal stimulus.  

Nobody knows how the experiment with negative interest rates will unfold. Investors can be comforted with the thought that sub-zero rates have persisted for three years in the eurozone and for longer elsewhere in Europe without too much drama. The Fed’s verdict on the US cash rate will probably hold more sway over economic outcomes in the next year or two. It can be said though that if negative interest rates do backfire, central banks and their desperate, even crazy, monetary policies will be sidelined. The world would be a step closer to money printing by governments via fiscal policy (often nowadays called helicopter money). Resources within the capitalist world would then be misallocated in a different way.

Financial information comes from Bloomberg unless stated otherwise.