Tag: negative interest rates

How Low Could They Go? Negative Interest Rates Explained

One of the first times negative interest rates appeared on the radar for many investors was in 2012, when the Danish National Bank pushed its deposit rate below zero. It seemed like an outlier event at the time, but since then more central banks in Europe and Japan’s central bank have also adopted sub-zero-interest-rate policies. This is commonly referred to as Negative Interest Rate Policy, or NIRP.

To understand the current global wave of negative interest rates—and whether it’s likely that the U.S. would embrace them—it helps to examine both their theoretical appeal and how they’re actually playing out in the real world.

The intended upside of negative rates

There is collectively almost $8 trillion worth of government bonds in parts of Europe and in Japan that are offering negative interest rates to investors. Buyers of these bonds essentially have to pay these governments money to buy their bonds. Said another way, investors who buy bonds with negative yields are paying the borrower. And while negative rates may not make sense at first blush, some central banks are experimenting with this strategy in an attempt to either boost inflation (European Central Bank and Bank of Japan) or to prevent their currencies from going up in value (Denmark and Switzerland).

By charging interest to commercial banks when they park their excess reserves overnight with the central bank, the European Central Bank and the Bank of Japan are attempting to encourage commercial banks to help jumpstart stalled economies, by forcing them to lend their reserves to businesses and consumers. The logic is that no commercial bank wants to lose money by parking reserves when they can make money by lending.

The incentive to lend should, in theory, drive more borrowing, which would lead to spending and investment. Consumers could see lower mortgage and loan rates, spurring home and auto sales. For businesses, lower rates could encourage investments in technology, infrastructure and staff, potentially leading to higher employment.

And what if negative rates were passed on to ordinary savers in the form of negative interest rates on savings accounts? In theory, that could also boost the economy. After all, you wouldn’t want to put your money into a savings account if it was going to lose money, would you?

With these potential benefits, going negative may sound like a legitimate way for a country to rev up its economy and reduce unemployment. But thus far, real-world results haven’t exactly turned out as planned. In fact, negative rates have led to a series of unintended consequences.

When negative rates don’t deliver positive results

In many countries where negative interest rates have been implemented, the results have actually indicated that there has been a diminished amount of credit available to individuals and businesses. The negative rates at the short end of the yield curve have sharply reduced the spread between short- and long-term interest rates, making lending less profitable for banks. As such, banks have responded by lending less.

Meanwhile, the negative interest rate environment has yet to spur much consumer spending. “The banks haven’t passed on negative rates to their depositors because they’re afraid that people will pull their money out,” says Kathy Jones, senior vice president and chief fixed income strategist at the Schwab Center for Financial Research. Instead, commercial banks in negative-rate countries have opted to increase certain fees they charge customers, in an attempt to recover some of their losses.

Could negative rates happen in the U.S.?

When Federal Reserve Chair Janet Yellen asked US banks to include a negative interest-rate scenario in their annual stress tests earlier this year, investors took notice. However, we believe these concerns are premature. A move to negative interest rates would require overcoming logistical—and possibly legal—hurdles. The Fed might even need the blessing of Congress. Given how controversial negative interest rates are, the Fed wouldn’t likely get this through Congress during an election year.

Also, Fed policymakers are well aware of the dubious record of negative interest rates when it comes to stimulating economic growth. “The lack of a boost provided by negative rates in Japan and the E.U. is another reason the Fed wouldn’t want to go down that path,” Jones says.

Moreover, the U.S. economy is outperforming most other major economies—and does not appear to be struggling with deflation. In fact, the Fed appears to be trying to raise interest rates, not lower them into negative territory, and the market seems to agree, for a change. Jones points to the Fed funds futures contract as a bellwether of U.S. monetary policy. The Fed funds contract is currently priced for more interest rate increases later this year.

“The trend toward negative rates is still a perplexing one that bears watching, especially if they move further into negative territory and achieve different results,” Jones says. “But for now, we don’t believe US investors should be alarmed. We believe that negative interest rates are unlikely to happen in the United States.”