Revisiting Negative Interest Rates

June 2014.

Mario Draghi was subdued, almost nonchalant as he spoke. “The rate on the deposit facility was lowered by ten basis points to −0.10 percent. The negative rate will also apply to reserve holdings in excess of the minimum reserve requirements,” he said. The move was expected. There were no gasps from the crowd; no shock and awe came from the attendees of the press conference. Journalists quietly scribbled notes. Few made eye contact with each other. Nevertheless, the statement was monumental.

A little more than five years have passed since Europe ushered in negative interest rates. The main fear throughout Europe was that deflation would take hold in the same way it did in Japan throughout the 1990s and 2000s. To fight deflation, the European Central Bank had to encourage consumer spending. Negative interest rates were the European Central Bank’s economic Hail Mary. The results have been disappointing.

Draghi hoped that imposing negative interest rates would incentivize spending and borrowing by punishing savers. The negative interest rates didn’t just apply to consumers. They would also apply to any idle cash the banks opted to hold in reserve with the European Central Bank. The belief was that the negative rates would make banks more apt to extend loans rather than hold cash.

By imposing negative interest rates, the European Central Bank would be deducting money from the banks rather than crediting them. In essence, European banks would begin being penalized for not making loans.

It didn’t take long for the negative interest rates to filter through the system. Within six months, the yield on five-year government bonds in Germany and Finland fell into negative territory, as did all government bonds up to seven years’ duration in Switzerland. Yields on two-year government bonds in France, the Netherlands, Belgium, Austria, and Denmark also began trading with a negative yield.

For some, the negative rates were a welcome surprise. Hans Christensen, a financial consultant living in Denmark, had refinanced his home years earlier with a floating rate mortgage having no idea that interest rates could actually turn negative. In January 2016, Christensen opened his mortgage statement to find that the interest rate on his home had floated to a negative 0.0562 percent. Christensen still had to make principal payments, but the bank was actually crediting him the equivalent of thirty-eight dollars each month.

“My parents said I should frame it, to prove to coming generations that this ever happened,” said Christensen.

What began as a strange European experiment has quietly bled into a worldwide phenomenon. More than $17 trillion dollars of global debt now trades at a negative interest rate, including $1 trillion in negative yielding corporate bonds.  

The logic is so perplexing that no economics textbook bothers to discuss the possibility which was previously thought implausible. Why are investors willingly taking on corporate credit risk for a guaranteed loss of capital?  I really have no idea.

Perhaps the better question is “how does this end?” Again, we have few answers, because no one in the world of economics has ever seen anything like this before.  We have no reference. But, for fun, I’ll lay out three possible scenarios:

1-      Asset values soar. In a search for yield, investors bid up the price of assets around the world. Real Estate prices soar, dividend paying stocks soar, inflation picks up and a bubble ensues. 

2-      Deflation sets in.  People lose confidence in the system and happily buy even more negative yielding debt for fear of losing more money in other asset classes.  Consumers stop consuming and the economy grinds to a halt.

3-      People shrug and continue on with life. This is best case option.  Years pass, the global economy muddles along, and everyone is able to refinance their debt at an extremely low interest rate.  Eventually rates begin to normalize and confidence increases. 

Policy makers are obviously hoping for option #3.  I think the best odds may be option #2.  While we don’t expect the negative rates to spill over into US markets, the global surge in negative interest rates appear to be here to stay… and as a result, the quest for yield is on. 

Sources:

https://www.cnbc.com/2019/08/21/negative-yielding-debt-poses-major-risks-for-investors.html

https://www.forbes.com/sites/miltonezrati/2019/09/23/negative-interest-rates-in-the-united-states-not-any-time-soon/#39d066805167

 

The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation. Any opinions are those of Brady Raanes and not necessarily those of Raymond James. There is an inverse relationship between interest rate movements and bond prices. Generally, when interest rates rise, bond prices fall and when interest rates fall, bond prices generally rise. Past performance is not a guarantee of future results.