Interest rates have turned negative
An ugly expression has gained prominence in economic and central-bank speak since 2008; the zero-lower bound. It’s most used to describe the 0% to 0.25% range that the Federal Reserve has targeted for the US cash rate since 2008. In modern phrasing, the zero-lower bound is referred to as a liquidity trap, the point where monetary policy becomes ineffective because zero is as low as central banks can cut interest rates.
No longer. In February, Sweden’s central bank became the first ever to cut its main policy rate to a negative number when it reduced its repurchase rate by 10 basis points to minus 0.1%. In March, Sveriges Riksbank cut its key rate another 15 basis points to minus 0.25%. The moves by the Riksbank are equivalent to the Reserve Bank of Australia cutting the cash rate to a minus number.
Six years earlier, the Riksbank pioneered negative deposit rates. This is the interest banks earn on so-called excess reserves held at a central bank, a rate that is a tool for setting a floor under the cash rate (in the same way that a central bank’s lending rate sets a ceiling). The Riksbank’s radical decision to set its deposit rate at minus 0.25% from July 2009 to September 2010 was mimicked by the Danmarks Nationalbank in 2012 and again in 2015 (now at minus 0.75%), the European Central Bank in 2014 (minus 0.2%), the Swiss National Bank in 2015 (minus 0.75%) and by the Riksbank again this year (minus 0.1%).
Negative interest rates are now prevalent across the European bond markets in a way they have never been in Japan for all its deflation and stagnation and never were in the 1930s. In March on any given day, about US$2 trillion (A$2.7 trillion), or about 25%, of the government bonds on issue traded at negative yields, even out to 10-year bonds in the case of Swiss bonds. (At the same time, positive yields were at record lows.) Over March, predominantly two- and five-year bonds sold by Austria, Belgium, the Czech Republic, Denmark, Finland, France, Germany, Italy, the Netherlands, Slovakia, Sweden and Switzerland traded at negative yields on the secondary market, while in recent months governments in Austria, Finland, France, Germany, Ireland, the Netherlands, Sweden and Switzerland sold bonds at negative yields. Corporate bonds in Europe are offering negative yields too, especially those denominated in Swiss francs. Some banks are even offering business loans and mortgages with negative yields. Bank charges, though, typically mean that businesses and home owners are paying to borrow.
The phenomenon of negative interest rates is prompting a rewrite of economic theories (which mostly lag reality anyway) and raises many questions. These include: How low can rates go? How long can yields stay negative? Will negative yields help revive economies? Could they, in fact, wreak damage?
The answers to these questions are debatable for it’s too early to judge. It’s likely, however, that interest rates can become more negative and that negative rates will be around for a while yet. What can be said with more certainty is that negative interest rates are the most radical of the unconventional steps central banks have taken since the global financial crisis erupted seven years ago. They place central bankers at the limits of their so-called independence for more-drastic steps require overt political assent that could destroy the freedom central banks enjoy to focus on tagetting inflation.
To be sure, real interest rates are more critical in terms of their economic impact not nominal ones. On that score, negative nominal interest rates fail to excite as real rates were far more negative over much of the 1940s to 1970s than they are today. Investors can still achieve positive real returns when nominal interest rates are negative so they could easily adjust to this new world. Basic day-to-day bank accounts essentially offer negative rates for they pay scant interest and charge fees. In that sense economies have coped with negative rates for ages. If economies stay languid and deflation-prone, central banks can pursue with more vigour the radical steps they have already taken, to prevent politicians from sanctioning steps that would dent, even strip, them of their image of independence. It must be said, too, that it’s false to think of central banks as operating above politics for interest-rate changes create winners and losers – negative nominal rates is just an even sneakier way for savers to subsidise borrowers. Whatever the truth of it, central-bank independence as investors perceive it today rests on a bet that negative interest rates combined with measures such as quantitative easing can revive economies. But nobody can say for sure what results negative interest rates will bring for they are too novel, even incomprehensible.
Falling prices
Economic theory does incorporate the concept of negative interest rates but only in the sense that it rules them out. The pessimism underpinning the concept of “secular stagnation” is based on a view that the interest rate level that would balance investment and savings and restore an economy to full employment – often called the natural or equilibrium interest rate – is now negative. The implication is that since that can’t happen the world will struggle.
Bonds offer a negative interest yield when the price paid for a bond exceeds the amount to be repaid by their sequence of coupon payments and the repayment of capital. Thus investors lose money, if they hold to bonds bought at negative yields to maturity. So why would anyone buy them (or invest in negative shorter-term money-market securities)?
The fundamental reasons are that deflation has taken hold and there is no sign that inflation will emerge as a threat any time soon. Bond prices are sensitive to inflation for they determine the real value of their future coupon and maturity payments. High inflation erodes the real value of these future payments and leads to a drop in the price of bonds, which means yields rise. The emergence of deflation in the Eurozone simply does the reverse and is the fundamental explanation for low and negative yields. Eurozone consumer prices fell 0.1% in the 12 months ended March, the fourth consecutive month when the 12-month outcome spelt deflation. Languid economies will suppress inflationary forces for a while yet.
The other reason for negative yields is the ECB’s open-ended asset-buying program that was announced in January and started in March. This program has boosted demand for bonds and upped their price enough to turn low yields negative. In essence, bond investors rationalise that they will make a capital gain when purchases by the ECB and national central banks drive prices even higher. So yields could go negative on a wider swathe of European bonds yields but the asset-buying itself won’t drive rates much further into negative territory for the ECB has said that central banks won’t buy bonds yielding less than minus 0.2%. Any ruction in Europe or elsewhere that boost the haven appeal of bonds or entrenches deflation expectations are likely to lead to larger negative yields on European bond markets and capital gains for investors.
The biggest barrier to yields going too negative is that investors and households can hold cash instead of money-market or fixed-income securities to preserve capital. But there are storage costs involved and businesses and consumers seem prepared to pay for the convenience of modern banking and for peace of mind from robbery.
How low could rates go and for how long? We shall see. Perhaps a bigger worry for bond investors is that events could propel yields back into positive territory, which would inflict hefty capital losses.
Will negative rates help or harm the economy? Capital markets (and their computer systems) are operating normally under the new world of negative rates so they aren’t disruptive. Over time, negative yields will surely prod consumers to spend and businesses to invest rather than save. But they threaten bank margins and the solvency of insurance companies (especially in Europe) whose business model is to sell products with guaranteed returns, for they can’t be met over the medium term in a world of negative rates. They make some derivatives more expensive especially currency hedging. Negative rates are certain to fuel asset bubbles. Negative yields on mortgage bonds are already blamed for a housing boom in Denmark. If rates stay negative for too long, it may lead to a misallocation of resources. Ordinary people may cause political ructions if their savings, particularly the compulsory component, are being eroded.
The radical cure
Central banks have other weapons to spur economies if negative nominal interest rates don’t defeat deflation and rejuvenate economies. Policymakers can thus boost economies by ensuring they have a larger negative real interest rate. There are two ways to do now; reduce the nominal rate even more, or take more radical steps to boost inflation.
A quick way for central banks to boost inflationary expectations would be for them to lift their stated inflation goals from about 2% to 4% or 5%. They can do this more surreptitiously by targeting nominal GDP growth of, say, 5%, which would imply an inflation rate of up to 5% when the economy is stalled.
The catch is that central banks would need new mandates from their political masters to do this, for they are not truly independent at all. In many cases (such as in Australia), the executive would need to sets new inflation targets for the central bank. In other countries such as the US, parliamentary approval would be required. In the case of the Eurozone, new treaties might need to be approved by parliaments or voters for the ECB to overly pursue an inflation goal well above 2%. The political firestorm that arguments for higher inflation targets would set off would probably make any of these changes difficult to say the least.
The other way to boost inflation, and a sure-fire way to do it, would torpedo the pseudo independence that central banks take pride in. This option is to “print money” in the timeless use of the expression to describe when a government is debasing a currency that is asset backed. Under a fiat (paper or non-asset-backed) monetary system, governments print money when they hand money they don’t have to the public via fiscal policy. Instead of borrowing the money by selling bonds to the public, they would force their lackey central bank to accept these bonds on their balance sheets via a few accounting fiddles. The central bank would do this by expanding its balance sheet, just as occurs under quantitative easing when central banks buy securities on the secondary market. When a government is printing money, the central bank is technically buying them on the primary market.
Printing money is often referred to as “helicopter money” because Milton Friedman famously used the image of the government showering money on its citizens from helicopters as a way to revive economies (and because analysts needed another term after quantitative easing was incorrectly described as printing money). If negative interest rates fail to revive economies, investors can expect the term helicopter money to become as ubiquitous as the zero-lower bound as policy makers search for even more revolutionary means to revitalise their economies.
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