Negative interest rates—a game changer?

Advanced economies' government bonds are and will remain a key asset class in sovereign institutions portfolios.

First, the evidence that negative policy rates have successfully generated growth or inflation is at best weak. Financial conditions appear to improve, at first. And financial conditions ease. But several recent papers highlight that low rates correlate with low inflation, perhaps because they probably cause longer-term expectations of price rises to weaken, rather than strengthen. It is also debatable whether negative rates have an impact on inflation through the channel of exchange rates, as currencies depreciate.

Like steroids, unconventional policy can be highly effective in short dosages, but just as long-term usage of steroids weakens bones, so too, below-zero rates can weaken the financial system. 

Second, the financial frictions of negative rates may be more severe in UK and the US. As professor Charles Goodhart and I have argued before, macroeconomic models typically take banks and other intermediaries for granted. But negative rates erode the profitability of banks, possibly reducing the availability of credit in the economy at a time when banks’ resilience is much needed.

Japanese banks, and more recently their European counterparts, have illustrated some of the problems caused by cutting rates. Japan’s regional banks have among the lowest returns on assets of any around the world. Larger banks have fared somewhat better, in part by lending more overseas. Japanese banks bought about a third of the higher-rated tranches of US collateralized loan obligations — investment vehicles that buy leveraged loans — in the past few years.

Quantitative easing programmes have helped the global economy and enabled banks to repair their balance sheets. Low rates have improved the affordability of their loans, reduced bad debts and lifted the value of assets. Japanese banks have relied upon capital gains from owning government bonds to offset pressures on profitability.

One counterargument is that the impact of negative rates appears to have been fairly benign in Sweden, Denmark and Switzerland, through the tiering of rates, where only part of banks’ reserves at the central bank are penalised. While these measures help, they are no panacea. Banks have sought to offset negative rates by charging higher fees, repricing mortgage spreads and, in some cases, lending more aggressively. The longer the experiment lasts, the more Danish and Swiss banks are having to pass on negative rates to clients. They could also weaken crucial short-term debt markets. The USD5tn in US money-market fund sector, which was a trip wire of the financial crisis in 2008, would surely be at risk. To overcome some of these challenges, significant regulatory changes would be needed to reduce the risks to banks and money-market funds.

But the politics of insulating institutions from negative rates cannot be taken as a given. It took the European Central Bank five years to introduce a tiered interest rate regime, for example, under which some of banks’ deposits are exempted from the negative rate.

Third, even the proponents of negative rates admit there is a point where the policy does more harm than good.

According to economists Markus Brunnermeier and Yann Koby, this “reversal rate” varies according to the characteristics of a particular banking system, but also changes over time, so central bankers would need to tread gingerly. A measure requiring such extreme caution is not one well suited to confront emergency conditions.

Thus far, the Federal Reserve, like the BoE, has judged that negative interest rates are not an “attractive” policy tool. But the view has become more nuanced on both sides of the Atlantic, with the Fed saying it is not considering negative rates “for now”.

But if the economy were in a prolonged recession from the pandemic aftershock, all measures to boost aggregate demand would be on the table — especially if fiscal policy were constrained by politics, or the rising size of sovereign debt burdens.

Another important but overlooked factor is the reduction in the use of cash. Academic supporters of negative rates have long argued that this would need to happen for negative rates to be pushed much below minus 1 per cent. COVID-19 is now prompting a shift to contactless payment and online trading, which could give policymakers grounds to argue that negative rates could be implemented with less risk.

Our base case is we that we won't get there. Risks to the base case is a prolonged recession, or if there a second wave of COVID-19 infections, and all of the issues that we all each of us have been debating about tribal scale.

Who is the most likely to go negative? Markets imply UK is first, followed by New Zealand and the US. For many investors, this is another reason to stay clear of some of the banks and insurers, however many banks already have trading at rock bottom prices because of the significance of certainty in the range of outcomes on credit losses, earning power and capital returns. And we can see a very strong correlation reasserting itself between European bank equities relative to stock markets, versus 10 year bond yields.

For investors, all this is another reason to steer clear of the banking sector. Many lenders are already trading at rock-bottom prices for fear of huge credit losses, weaker earnings and low or no dividends. Smaller banks would suffer most.  Correlation of European banks relative to markets vs 10 year bund is strong

Pension funds’ asset allocations are increasingly being distorted by negative rates, too. One of the most striking consequences has been to encourage investors out of Japanese and more recently European markets and into US credit and equities instead. The thirst for yield has led to a self-reinforcing bid for longer-dated bonds. As most savers target a particular level of retirement income, the lower rates go the more they will need to save to hit their targets, reducing their ability to spend today.

Moreover, a 2018 report by the Bank for International Settlements argued that the solvency of insurers and pension funds would be a larger concern than that of banks, in a scenario of very low rates for very long periods. Many insurers have so far followed a “barbell” investment strategy with government bonds at one end and large exposures to riskier corporate debt at the other — both of which could be under pressure in a negative rate situation.

The debate over negative rates will be kept alive by concerns that countries’ economic-policy arsenals are insufficient to deal with the effects of the COVID-19 crisis. But many investors will be hoping central banks stick to more conventional measures such as bond-buying, forward guidance and yield curve control, alongside fiscal policy. If policymakers overlook the risks of negative rates to the financial sector, central bankers could be hurting more than they are helping.

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