Negative interest rates – Quo vadis?

20 February 2020

6 minute read

A negative rate monetary policy by some major central banks has had major implications for the interest rate environment and capital market flows in recent years. The unconventional rate policy in Europe has lately contributed to an increasing debate among economists, investors, politicians and savers alike: how long will this policy last, is it sustainable and how to manage wealth at such times.

We turn to some of the most common questions below to try and provide more guidance on the strange world of negative interest rates.

How long have there been negative rates and why were they put in place?

The negative interest rate environment, as witnessed in the eurozone, Denmark, Japan and Switzerland, is primarily the result of monetary policy. In the eurozone, negative interests arrived in 2014. The European Central Bank (ECB) was trying to tackle the threat of deflation, but equally to correct earlier policy “mistakes”. While the US Federal Reserve had been quicker and more committed in its response to tackle the aftermath from the financial crisis in 2008, the ECB was still in hiking mode (see chart).

The second “mistake” in 2011 occurred as a result of the ECB’s “overconfidence”. The central bank tried to leave the phase of accommodation behind by hiking rates too early back in 2011 while the European economy was not ready for it.

US interest rates have recovered from their lows

Have negative rates accomplished their mission?

Yes and no, is the short answer. Apart from providing cheap and much needed liquidity for weaker banks in the eurozone, negative rates have supported spending, especially for liquidity-constrained companies and households. Negative rates have also supported European loan growth which has picked up at the corporate and household level (2.6% and 3.5% respectively) since implementation. It also triggered currency depreciation, a very welcome byproduct for the more export-oriented euro countries.

However, the main goal to bring “inflation at or close to 2%” seems far out of reach and inflation expectations, as reflected by breakeven rates trading well below 1% in Germany, France and Italy, suggest that this won’t change soon. ECB president Christine Lagarde has expressed many times that although the current monetary stance provides the support needed, it requires additional fiscal stimulus to revive demand, growth and thus inflation.

What are the side effects?

Negative rates do not come without side effects, spurring a large debate. Firstly, negative rates shrink savings. In the eurozone Germany, France and the Netherlands are among economies with a high savings ratio. Negative rates, especially in these countries, are hugely unpopular and politicians are putting more pressure on the ECB to change course in order to gain votes.

Secondly, negative rates put additional pressure on eurozone banks’ profitability. While “tiering” (partial exemption of negative charges) helps, it does so only to a limited extent. Thirdly, negative rates as much as ultra-low rates inflate financial assets and encourage asset managers and investors alike to consider riskier assets.

Low yields have also incentivised companies to take on more debt, given it is more affordable. If persistent for a long period, this can lead to further imbalances in the quality of cash flow generation and assets in general. While the ECB is “attentive to potential side effects”, chief economist Philip Lane recently reiterated that Europe is far from the “reversal rate”; the level at which the negative effects outweigh the positive.

What next for rates?

Perhaps at this stage it is worth taking a look at the interest rate curve as it is the market implied path for short term rates. The spot and forward rate swap curve is fairly flat for debt with maturities of up to five years, while some inversion in the 1 to 24 month area implies that some investors even see a possibility of a further cut in rates of 10 basis points in Europe to -0.6%.

With subdued global growth prospects, especially for the German manufacturing sector, it seems very likely that inflation will trend even lower which should provide more ammunition for further rate cuts.

But given the increasing political pressure, the ECB might be tempted to leave rates at current levels for now. ECB president Lagarde’s strategy and call to European politicians will be clear: provide significant fiscal stimulus in order to revive inflation in your economies and we will be able to raise rates again. Anything else won’t work.

While stimulus efforts are discussed, we doubt, at this stage, that this will be enough to bring inflation back to where rate increases to 0% can be justified. Investors are likely to face negative rates for longer. Sweden most recently has started the experiment and abandoned negative interest rate policy with a hike back to zero. The success or failure will be a good indicator for the ECB if such a path should be chosen at this fragile stage.

What are the options?

Negative rates bring another dimension to asset allocation. In such conditions safe assets, such as German or French government bonds, provide a loss with 100% certainty if held to maturity, while riskier assets provide some return with a probability of losses.

The good news is that investors have several options available to counter this situation. Increasing duration/tenors on bonds, to a certain extent, can help to achieve higher yields, while longer duration bonds outperform most assets in a “recessionary” scenario. Otherwise, investment grade bonds, for example, provide additional yield without extending duration excessively. By selecting issuers with stable cash flow and robust balance sheets, risks should be limited.

Assets like equities, real estate or inflation-linked bonds generally help to protect the real value of assets. The optimal solution lies within the right asset mix and is achieved by investing cautiously, without taking “excessive” risks.

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