The Impact of Negative Interest Rates

Source: Macquarie Investment Management

Executive summary

In a world of unconventional monetary policy, the use of negative interest rates has been the most recent tool used by central banks as they seek to spark growth where other policy measures have failed. Negative rates are essentially interest rates that are set below 0% by central banks with the aim of stimulating growth through increased lending.

Following our analysis, we believe that negative rates are more likely to have a negative impact for economies and will be of little benefit to consumer and business spending.

Our research suggests that negative interest rates may actually lead to higher financial asset price inflation in markets, particularly for defensive assets, but with higher volatility due to a lack of fundamental support. For investors, we suggest a better understanding of the risk profile of their portfolio and an allocation to defensive assets remains a prudent approach going forward.

What are negative rates?

Negative rates refer to interest rates set by central banks at less than 0%. As the chart shows, countries with interest rates less than 0% include Sweden, Denmark, Switzerland, Europe and Japan. Historically, negative interest rates have only ever been observed once during the Global Financial Crisis (for a brief period and limited to Treasury Bills) and not seen even during the Great Depression.

Policy makers, faced with continued uncertainty in the outlook for economic growth, are looking for additional means to stimulate growth and increase lending to businesses and consumers. For now, negative interest rates apply only to banks’ deposits (also known as reserves) at the central bank. However, as we discuss in this article, this does have wider implications for markets, economies and investors.

Our research finds that contrary to the intent, negative interest rates are likely have a negative effect on economies for the following key reasons.

What does this mean for the economy?

Act as a ‘tax’ on banks

Reducing their income, banks will be charged interest to maintain reserves at the central bank. Though individual banks may seek to reduce these reserves through increased lending and holding non- cash assets, for the overall banking sector this will drag on profitability. This also means they have to squeeze more margin from other areas, which leads to the second point.

Decrease deposit rates and increase lending rates

As banks suffer lower profitability, this will likely affect other sectors as they try to offset their ‘tax’ by lowering the savings rates for depositors and/or raising lending rates to their customers.

Create incentives that lead to unintended outcomes

Since business spending, particularly capital expenditure, is more closely related to expectations of future income than cost of funds (as per the table below), lower incomes from negative rates are unlikely to improve on these expectations nor drive capital expenditure. Furthermore, the incentive to offset the cost of negative rates (as a result of lower expectations of future incomes) could result in effort diverted to more short term financial market activity to the neglect of longer term business capital expenditure, which is not good for future productivity growth and long term prosperity.

Overall, the cost of negative interest rates will eventually affect all other sectors and wider parts of the economy, exactly as a tax hike would. Without any increase in expenditure, the impact on the economy will be fundamentally slower growth.

How does it affect markets?

As banks look to hold less reserves in response to negative rates, they will shift from reserves to other low-risk assets such as government bonds. As net demand for these assets increases, prices increase (and bond yields fall).

Eventually banks will be forced to allocate to other assets which could include riskier assets such as equities, in order to maintain their profitability. As bond yields fall, other market participants will likely intensify allocating to more risky assets in a ‘chase for yield’.

What this means is that asset prices will likely increase,firstly, for lower-risk fixed income assets such as bonds (see chart below) since they are the asset closest to bank reserves in terms of risk. However, the effect on other assets will depend on whether the ‘chase for yield’ will offset the impact of income losses – for example, how equities perform will depend on the impact on banking sector profitability.

It is important to note that the increase in asset prices in this scenario is not related to any underlying fundamental factors. It is solely a response to the distortion in incentives caused by negative rates. The end result? Expect more volatility in asset prices.

What can investors do?

The environment discussed above is characterised by low economic growth but higher asset prices, due to distorted incentives.

Investors may also want to consider the risk profile of their portfolios, as we believe asset prices in some asset classes may continue to be distorted by central bank monetary policies.

As fixed income investors we look to take advantage of opportunities in particular parts of the bond and credit markets, while remaining steadfastly aware of the risks and potential for the accommodative central bank policies to hide problems, not fix them.

For investors, these insights can provide inputs into strategic plans and the possibility to explore specific investment opportunities.