Making sense of negative interest rates

Making sense of negative interest rates

When a handful of currencies recently made the headlines over their negative interest rates, they effectively challenged a bedrock assumption across centuries of financial history that when you lend somebody money, they usually have to pay you for the privilege.

While a decade ago, negative interest rates were little more than theoretical curiosity, now it’s the stated policy of some of the most powerful global central banks, and this is something the market has struggled to get its head around.

Clearly, negative interest rate policies present unchartered waters for finance, an economy and even for the definition of money. But if a central bank is adopting a negative interest rate policy, it’s a pretty good sign that the economy is in worse shape than initially envisaged.

Last-ditch tool

Negative interest rates are central bankers' new tool in fighting anaemic growth and low inflation, by encouraging business investment, aiding consumer spending, increasing the value of the share market and other risky assets, lowering the value of a country’s currency, making exporters more competitive – and creating expectations of higher future inflation.

However, it’s important to remember that the (negative) rates being referenced in many of these news-feeds are rates controlled by central banks, typically overnight rates for banks borrowing from the central bank.

Earlier in March 2016 two central banks set their controlled rates below zero (Switzerland and Sweden), two more (ECB and Bank of Japan) set the rate at zero, while the ECB lowered its rates below zero (-0.3%) on March 10.

While we’ve seen short-term interest rates turn negative before, this is the first time we’ve actually faced negative long term rates on two currencies – the Swiss Franc and the Japanese yen, with the very real possibility that they will be joined by the Euro, the Danish Krone, the Swedish Krona and even the Czech Koruna in the not too distant future.

At face value, it looks as if the Swiss and Swedish governments are embarking on using savers as guinea pigs to find out what they’re willing to pay for the convenience of staying cashless.

Interestingly, when negative interest rates didn’t result in mass withdrawals from the banking system, larger central banks in need of easier money started moved in the same direction.

Even the American central bank (The Fed) said it was taking a look at the negative interest rate strategy.

Lower than zero for longer

Here’s a crude but useful example of how negative interest rates work. If you’ve recently bought a two-year Swiss government bond, you’d have paid a price that resulted in a yield of negative 1.12%.

Even 10-year Swiss bonds have a negative rate, which really tells investors to expect below-zero rates to persist in Switzerland for many years to come.

But if you thought negative interest rates were the sole domain of central banks, you’d be wrong. Admittedly, negative-rate corporate debt is still rare, but we have seen them with corporate bonds issued by the Swiss food giant Nestle.

Hobson’s choice

Believe it or not, there are some perfectly rational reasons why nominal negative interest rates could be favoured over just holding on to the money as cash.

For starters, while stuffing cash under your mattress may appear to be a real choice, you will increase your exposure to theft and may have to invest in costly security measures.

Secondly, some transactions are extraordinarily cumbersome to get done with cash, like buying a house. 

Unintended outcomes

Admittedly, low or negative central bank rates are a mana from heaven for borrowers.

However, one of the more sinister unintended consequences of interest rates hitting zero or lower is that some investors, especially those in need of fixed income will look in dangerous places to find it.

In other words, having decided against stashing money under the mattress or accepting negative interest rates, investors may be tempted to take their money out of the bank and invest it in other assets, such as bonds, stocks or even riskier investment vehicles.

For example, the next Bernie Madoff-type investment guru may only need to offer 4% in this market to attract investors to his fund, and this is where a lot of investors exposed to zero or lower interest rates could get into trouble.

What it means for Australian investors

Despite lower earnings forecasts for the Australian companies, the RBA’s official cash rate of 2% proves convincingly that the Australian economy is in pretty good shape, relative to other developed economies, especially in Europe and Japan.

Recent momentum behind negative rates has arguably put Australia front and centre, and has played a big part in spurring the Australian dollar.

Negative rates also highlight the relative strength of the Australian economy, which is one of only 12 governments with an AAA rating worldwide. We also have a $700 billion deep and liquid government bond market, a Westminster legal system, and equally important a central bank with armour to go on cutting rates.

However, judging by the state of the economy, this remains unlikely.

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