Chris Siniakov explains how negative interest rates work, what their intended purpose is, and whether it is having the desired effect in a highly stressful economic period where central banks are reaching a dead-end on what it can achieve with monetary policy.
Negative interest rates. It sounds weird, and it’s unusual. To help the bewildered investor we explain some of the key issues and practical implications of negative interest rate policy.
How did we get here?
Since the Global Financial Crisis (GFC), global central banks lowered interest rates to stimulate growth and/or to raise the inflation rate.
To assist monetary policy to achieve its goal(s), unconventional quantitative easing measures were also introduced to help troubled segments of the economy and to quell the financial panic.
Monetary policy rates approaching zero and quantitative easing combined to compress term yields through the scarcity of assets for purchase and declining term premia. Nonetheless, global growth has remained persistently sluggish and inflation rates in decline. Central banks failing to meet their mandate appeared to be running out of tools.
While smaller central banks such as the Danish Nationalbank and Swedish Riksbank had temporarily adopted negative rates in earlier years, prompted by downside inflation surprises, the European Central Bank was the first major global central bank to go negative in June 2014. As at February 2016, five central banks had adopted negative interest rate policies — the European Central Bank, Swedish Riksbank, Danish Nationalbank, Swiss National Bank and most recently, the Bank of Japan (see chart below).
How does negative interest rate policy (NIRP) work?
In general, most central banks have taken a similar approach. The financial system is structured so that commercial banks maintain a minimum level of reserves against their liabilities with the central bank. Traditionally these are interest bearing accounts.
Unfortunately, when loan demand is weak, commercial banks tend to hold more cash in the central bank reserve account than is necessary. This hoarding behaviour dulled the transmission impact of stimulatory monetary policy settings.
Under NIRP, commercial banks now need to pay interest on balances above the required reserve levels. Hence, in theory, NIRP incentivise commercial banks to lend out their reserves to stimulate the real economy through consumption and investment.
When working properly, negative interest rates affect the real economy through multiple transmission mechanisms including:
Deterring savings: Negative interest rates, especially when passed along to consumers, serve as a tax on savings and should, in theory, encourage consumption and investment.
Asset price appreciation: A widely held belief among economists is the wealth effect: consumers spend more when prices are appreciating in widely-held assets. For instance, the Bank of Japan has made substantial direct purchases of equities, pushing up prices. Negative interest rates generally affect asset prices in a more indirect fashion by moving investors out the risk curve.
Increased risk taking: More commonly referred to as reaching for yield, negative interest rates force investors to take more risk to achieve a desired rate of return. The risk can take multiple forms including purchasing assets with lower credit qualities, longer durations or switching to asset classes with higher levels of volatility.
Raising inflation: While it is impossible to say with certainty what a central banker’s greatest fears are, we imagine that a deflationary spiral is among the top-five. Negative interest rates can help influence expectations of higher prices in the future (perceived as looser monetary policy) and encourage consumption in the short-term.
Exchange rates: Welcome to the currency wars. While central bankers may not discuss it overtly, there are competitive advantages associated with a weaker currency. However, currencies are a zero-sum game. When a country stimulates growth and exports deflation by weakening its currency, it does so at the expense of its neighbours.
Will negative interest rates work?
Central bankers take the position that slightly negative interest rates are no big deal. Bank customers have always stored assets in their cheque accounts that pay zero interest. After fees, these accounts have effectively a negative interest rate. This has happened for decades across many advanced economies.
Others point to real interest rates — that is, nominal interest rates minus the inflation rate. While negative nominal interest rates are a relatively new phenomenon, central banks have long dealt with negative real interest rates without any untoward consequences.
The market participants, however, argue that negative interest rates have affected confidence. There was a long-standing perception that interest rates have a zero lower bound. The fact that central banks have started moving below zero sends a signal to markets (and the general population) that we are in a highly stressed period, and that the central bank is nearing the end of what it can achieve with monetary policy.
In the short-to-medium term, financial markets appear to be looking through these concerns but whether or not negative interest rates will adversely affect the real economy will only be known after this experiment matures.
Are negative rates working so far?
It is still early days and difficult to measure the impact of negative rates on the real economy. The April 2016 ECB Bank Lending survey provided some data to help answer the question “is it working?”.
The chart below shows that after a much extended period of subdued (most of the time negative) credit growth since the GFC, the most recent survey reports a moderate pick-up in demand for loans from enterprises in the six months since negative rates were implemented. Households, however, have shown no discernible pickup in lending volumes.
While the moderate pick-up in demand for loans from enterprises can be viewed encouragingly, it is important to keep it in perspective. It was off a very low base, and the vast majority of banks see no impact on lending of negative interest rates. The chart below helps demonstrate this with negative rates having no impact on lending in corporate, housing and consumer credit.
Unfortunately, we are not optimistic that the future ECB Bank Lending surveys will report any positive results, with the shock of Brexit now reverberating across the European continent. Business and consumer confidence surveys have reported a decline in current conditions and future intentions, which do not bode well.
How do negative rates impact investors?
While it is useful to understand the theoretical background to negative rates, let us now assess the tangible impact on investable assets.
The search for yield has never been stronger. The breadth of markets affected by negative interest rate policy and quantitative easing is far greater than the five markets that have implemented negative rates. The chart below highlights graphically the negative bond yields for across multiple markets. Beginning with Switzerland, the chart below shows that 76 per cent (US$61 billion) of all bonds are trading below zero per cent since May 2016, affecting all maturities from one year to 10-year bonds. In Japan, US$4,768 billion of government bonds are trading below zero per cent.
In Europe, negative rates also extend beyond government bonds with some corporate bonds also being issued at a negative yield (see chart below).
At the benchmark index level, as at May 2016, over 23 per cent of the Barclays Global Aggregate index is trading with negative yields (see chart below).
Policy decisions always face the risk of unintended consequences.
One of these relates to duration risk. As yields approach (and now move through) zero, the duration of the underlying security consequently increases. Hence, the traditional risk-adjusted returns offered by long-dated nominal bonds are remarkably poor. Despite the obvious deterrent of a potential negative return, there are still investors willing to hold long-dated bonds for diversification benefits or, in some cases, because they are mandated by stakeholders or regulators to hold fixed income assets.
The reach for yield can also result in investors under-pricing credit/default risk and the liquidity risk of their investments. Policymakers are sensitive to these risks and have resorted to stricter supervision and macro-prudential policies. But their reach beyond the regulated sector is untested.
Chris Siniakov is the managing director, Australian fixed income, at Franklin Templeton Investments.
