Central banks around the world are developing a newfound fondness for experimenting with negative interest rate policies (NIRP) — despite unknown consequences and what appears to be a chilling effect on financial markets. It’s a topic PIMCO has been following closely in recent months (see our paper, Negative Interest Rate Policies May Be Part of the Problem.)
PIMCO believes there are very important differences in terms of the impact on the financial system when central banks are reducing policy rates into negative territory versus lowering positive rates. The pressure on the financial sector became more acute when the European Central Bank (ECB) and Bank of Japan (BOJ) joined central banks in Sweden, Denmark and Switzerland in instigating negative interest rate policies and suggested they were prepared to do more.
Banks under stress
Banks, in particular, have borne the brunt of these actions. Because they are unable to pass on negative interest rate costs to their clients, bank profits have come under pressure. With banks no longer able to rely on profits to recapitalize themselves, we’ve seen a tightening of lending standards, particularly in some of the more fragile banking systems in Europe.
Spillover effects
Consequently, we’ve seen a new wave of stress spill over into other sectors of the economy, with credit spreads widening. The cost of borrowing for many sectors has actually gone up and credit availability has declined.
Heightened potential for currency wars?
There are reasons to be concerned about the external macro effects. Certainly, many negative interest rate policies — particularly in the case of some of the smaller central banks — have been primarily designed to weaken their respective currencies. As large economies’ central banks, like the ECB and BOJ employ these NIRPs, it raises the risk of offsetting reactions by other large economies, raising the specter of currency wars.
This creates greater volatility and market dislocation. It also creates the real possibility of a backlash in terms of trade tensions if a country is perceived to be using NIRP to gain an unfair advantage by manipulating the price of its currency.
Implications for investors
Negative interest rates may also act to increase risk aversion. As yields on government and other high-quality bonds are pushed into negative territory, holding these bonds represents a guaranteed loss of purchasing power if held to maturity. The response of some investors will be to pull back and take less risk. Others may be encouraged to take more risk to compensate for the loss of income.
What are the alternatives for global central banks that need to stimulate their economies? Monetary policies focused on easing credit conditions more broadly — buying credit-related instruments such as bank loans, for example — may prove far more effective at easing financial conditions than NIRP, in PIMCO’s view.
Video: Negative Interest Rates:
Unconventional Policy Poses Important Risks
PIMCO’s Mather discusses the potential consequences of negative interest rate policies for the banking system and the broader economy.
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By Scott A. Mather
May 9, 2016
Scott A. Mather is a managing director and chief investment officer of U.S. Core Strategies; he is based in Newport Beach, California.
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