Negative interest rates are not new; Europe started experiencing negative rates nearly a decade ago during the global financial crisis, and now globally some $13.5 trillion in government debt (most of it issued in the Eurozone and Japan) offers subzero yields. What is new: speculation that US rates might also go negative. While we do not think negative rates will happen in the US any time soon, I thought I would discuss how negative rates work and their implications.
How do negative rates work? Counterintuitively, in a negative yield scenario, a lender in effect pays the borrower to borrow money. For example, a bank (the borrower) might not pay interest on your savings account; instead, it charges a periodic fee so in essence your return is negative. In the bond markets, negative rates are a bit nuanced, lenders and investors aren’t writing checks to borrowers on a regular basis. Here’s an example of how this pricing works. The price at maturity of a negatively yielding bond will be lower than its purchase price. So a one-year government bond with a 1% coupon might be purchased for $102, with a payout of $100 at maturity. The yield to maturity on this bond would be roughly -1%. Why would an investor accept a negative yield? Because there may not be other “risk-free” options for storing cash, besides a safe deposit box, which may not be feasible for large and institutional investors.
How did rates get negative in the first place? Negative rates are a cascading phenomenon that starts with central banks setting what is known as their target interest rate. During the financial crisis, central bankers in Europe and then Japan lowered target rates to zero (and nearly zero in the US), meaning big banks in those countries were getting nothing for storing their excess cash in central bank coffers. Zero rates were meant to stimulate the economy by encouraging banks to lend out their excess cash so businesses and consumers could borrow more and invest. This stimulus did not have the desired effect, so central banks continued lowering their target rates below zero. Keep in mind that central bank target rates are the “risk-free rate” used to determine the pricing of nearly every investment. When the risk-free rate falls, the current cash flow generated by financial assets (stocks, bonds, real estate, etc.) becomes more attractive and their prices tend to rise.
Are negative interest rates good or bad? In theory, lowering interest rates from 1.75% to 1.50% is the same as lowering them from 0% to -0.25%. And central bankers abroad believe that zero and then negative rates have kept economies from recession. To date however, economies that have experimented with negative rates haven’t generally seen substantial economic acceleration, and central banks that have gone negative have stayed there with no end in sight.
I am more inclined to think that the potential risks of negative rates outweigh the benefits. The first thing that is problematic is the message sent by negative rates: The central bank is so concerned about a downward economic spiral and deflation that it is willing to use extreme measures and allow otherwise nonsensical transactions to take place. The response from consumers and investors, understandably, hasn’t been enthusiastic; instead, they have grown more risk averse and less optimistic about the future, as signaled by economic indicators. In that sense, negative rate policy appears to be counterproductive to some extent. Of course, the opposite could also be true: absurdly easy monetary policy could eventually incentivize outlandish risk-taking and cause breakaway inflation, even though results so far haven’t come close to that.
Negative interest rate policy is a little like looking into a funhouse mirror. Everything we know about the financial system is based on a positive risk/reward trade-off, so when interest rates are negative financial decision making can be both backward and distorted. In a negative interest rate environment, debt becomes an asset, borrowers have no reason to pay back debt early, and while banks are still rewarded to lend, they have to worry about retaining deposits. As others have asked, what happens to bank profitability and confidence in the banking system when small bank account holders decide to keep money under their mattresses instead of paying higher fees or interest on their bank accounts? Would we be able to get out of negative rates once there? Those questions are probably the most significant concerns. Europe and Japan do not answer either yet, since their banks have not actually started to charge interest (or levy higher fees) on small accounts. At least not yet.
Will we see negative rates here in the US? It is likely that US interest rates will fall further, even if they do not fall into negative territory. For one, the preponderance of fundamental data suggests we are nearing the end of the longest US economic expansion on record. Second, the Fed has cut interest rates three times so far in 2019 — and we are now at a range of 1.5% to 1.75% — in spite of record low US unemployment and tame inflation. Lastly, it is hard to see why US government debt — generally considered the highest credit quality by investors worldwide — should be offering higher yields than the bonds of less creditworthy countries. My guess is that US rates are headed even lower in the quarters ahead with the caveat that a US-China trade deal that includes tariff reduction could spark renewed market enthusiasm and elevate rates for a short while.
The Federal Reserve has indicated it would consider a negative target rate under the right circumstances. The question the Fed will have to ask itself is whether fighting an economic slowdown warrants the risks of joining Japan and Europe in the quagmire. I think the broader implications for negative interest rates referenced above and the experience of other key developed markets will give the Fed pause.
But let’s be more optimistic. The grass is still greener here in the US as interest rates remain positive today. As long as there is a rate differential providing investors with a substantially greater yield in the US, negative rates will likely be viewed as an albatross on Europe and Japan preventing acceleration of growth in those regions. But what if at some point investors find that all developed market rates are roughly the same? Perhaps they would then focus more on the fundamental opportunities presented. Coordinated, negative rates across the US, Europe and Japan could then perhaps result in meaningful growth for all developed markets, but ideally, the US shouldn’t need to risk breaching zero to allow that to happen.