Since 2014, central banks in Denmark, the Eurozone, Sweden, Switzerland and most recently Japan have moved their interest rates into negative territory. It’s a high-risk experiment and a very rare phenomenon, the effects of which are relatively unknown. Rates below zero have never been used before in an economy as large as the Eurozone.
What are negative interest rates?
A negative interest rate is where central banks charge negative interest: instead of receiving money on deposits, depositors must pay regularly to keep their money with the bank. Negative interest rates punish banks for parking their excess funds with the central bank, by making it more expensive for banks to hoard cash. The deposit costs are supposed to encourage the banks to lend or invest.
In times of economic decline or crisis, where consumers may be less willing to borrow and, normally, banks less willing to lend, the negative interest rate is supposed to encourage lending and borrowing.
Why did the central banks choose to use this rare stimulus measure?
The main job of central banks is to keep inflation under control and to support economic growth and employment. Across the Eurozone and in Sweden, the aim of negative interest rates is to prop up inflation and fuel economic growth. In Denmark and Switzerland, the objective is to prevent the currency from appreciating too much. The Bank of Japan implemented negative interest rates in an attempt to revive growth, stimulate spending and increase inflation to their 2% inflation target.
Stephen Poloz, the Governor of the Bank of Canada has stated that negative rates are not out of the question in Canada, should the economy need a jump start. Given that possibility, below we take a look at the possible pros and cons of a negative interest rate policy
Theoretical Pros of negative interest rates
Should motivate banks to lend
Usually, a bank can choose not to lend and hold reserves instead, but because of the costs now associated with holding excess reserves at their central banks, banks will be motivated to lend.
Stimulate economic growth and raise inflation
Negative interest rates should reduce borrowing costs, increasing demand for loans that will be spent on consumer goods like homes, vehicles etc.
Companies will be willing to borrow, invest and hire
As with households, interest rates below zero should increase demand for loans to invest in businesses and hire workers, supporting the central bank’s goal of full employment
Prevent currency appreciation
Negative interest rates make the local currency unattractive to investors
Keeps exports competitive
Theoretical Cons of negative interest rates
Hurt bank profits
Banks are unlikely to pass along negative interest rates to consumers because if they do, consumers may hoard their cash instead of paying interest on deposits. These deposits are a vital source of capital for lenders
If they absorb the costs of negative interest rates, this will squeeze bank profits
This could hurt the banking sector and create more volatility in the European markets
Could incite a currency war
In a bid to keep their exports competitive, currencies may engage in competitive devaluation
Investors may invest in riskier assets, investing beyond their risk tolerance in order to seek a higher rate of return
If banks are worried about the state of the economy, despite being charged interest to hold reserves, they will be hesitant to lend, because of concerns over their customers’ credit-worthiness
If consumers are pessimistic about the economy, despite extremely low rates, they will start paying off existing debts instead of borrowing more
What does this mean for investors?
If the cost of borrowing is close to zero per cent, consumers who are secure in their jobs can benefit from very low-cost borrowing. It is possible, however, that banks would choose to pass some of the costs along to their retail and corporate customers, charging them to safeguard their cash.
Investors would be faced with a bit of a dilemma. A negative interest rate environment does not bode well for traditional bond yields. As a result, investors may need to explore alternative income investments that present more risk but better potential returns. Some of these types of investments can be found in lower risk mutual fund products (e.g. unconstrained bond funds – click here to download an interesting strategy paper on this topic), and some can be found in investment products available only to accredited investors (e.g. asset-based lending, and receivables factoring strategies).
If you’d like to learn more about what alternatives you have in a low or negative interest rate environment, speak to your Investment Advisor.