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The World with Negative Interest Rates

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Let’s assume for a second that the majority of us out there don’t really understand negative interest rates – which isn’t all that hard given most people don’t understand interest rates or negative numbers, much less the combination. We see the headlines, we read a paragraph or two, but the very concept is so backwards, it would be like getting a tax break for buying lottery tickets, or getting paid by local government to park on certain streets, or one of those Google interview questions.

What are Negative Interest Rates?

Just what are negative interest rates? Well, a normal interest rate is the earnings or yield, an investor or saver gets for loaning, investing, or depositing their money with a bank or company or so forth.  The borrower promises to pay the money back, with interest.  Negative interest rates are quite simply the opposite.  Where instead of getting your money back plus some amount, the borrower promises to pay you back the money you lent them, minus some interest rate. It’s like paying for a safety deposit box, or a storage unit, or a wine cellar.  You put your stuff (money) in there, they protect it and give it back to you after charging a storage fee.

But this is money, not your old couch. Who in their right mind would want to pay a storage fee for money?

That’s the point. A negative interest rate can be used as a monetary tool to incentivize banks to lend more freely (or else they’ll pay the central bank to hold their very large deposits), and potentially incentivize individuals and companies to do more than keep their money sitting at the bank – perhaps making them spend it, or invest it, to forego a charge on it.

Will the U.S. Go Negative?

Back in February, Federal Reserve Chairwoman, Janet Yellen publically said that negative interest rates were possible.

“We’re taking a look at them … I wouldn’t take those off the table,”

That’s a swift change in potential policy coming from the Federal Reserve. Just months earlier, they raised interest rates for the first time in nine years, with hints of raising rates again in 2016, but that now seems like a pipedream.

The Global Scope of Negative Interest Rates

Negative Interest rates may be a foreign concept to the United States, but it’s certainly not foreign to countries outside of the US. Per the Economist:

On January 29th the Bank of Japan (BoJ) said it would cut its benchmark interest rate below zero, to -0.1%, in an attempt to counteract the effects of falling oil prices and China’s slowdown. The BoJ is following the lead of several central banks in Europe, including the European Central Bank (ECB), which first resorted to negative rates in 2014…[at -0.30%].

Back in February, Bloomberg estimated that $7 Trillion worth of global bonds had Negative Yields. That comes out to be around 30% of the global bond market. Bloomberg has a scale representation of what interest rate category foreign bonds fall into.

Bloomberg 7 Trillion in Negative Rates

Fast forward to April, and BlackRock now estimates that 38% of the global bond market have negative interest rates. That’s not even counting the countries and government agencies that are above 0% interest rates but remain at historic lows. BlackRock gives a great comparison of where interest rates were back in 2000 compared to today.

We now live in a persistently low rate environment, where decent yields are scarce. In 2005 virtually every asset in the Barclays Global Aggregate Index and Global High Yield Index was yielding at least 3 percent (with the exception of Japanese Government Bonds), and there were a variety of duration options. A decade later, only relatively small pools of assets (such as high yield and emerging market sectors) are offering 3 percent yield or greater, according to our analysis , and the higher yields require extending duration. See the charts below, where the size of the bubbles represents the size of each respective market.

2000 2016 Comparison of Interest Rates

Taking the U.S. out of the equation, the trend seems to be moving towards more negative interest rates, not vice versa. Late last week, the Bank of England pulled a Janet Yellen, suggesting that negative interest rates are possible.

Theoretically, I think interest rates could go a little bit negative.”

While the ECB said they’re leaving the door open for further interest rate cuts in the future.

Why Go Negative in the First Place?

It’s important to remember that just a couple years ago, negative interest rates were considered highly experimental, and now it’s a global trend. How did we get from then to now? That is a simpler answer. Central banks lower interest rates to encourage people and businesses to spend their money, and when you’ve lowered all the way to zero already, there’s only one place to go if they want to further incentivize  people to spend their money; although we’re reminded of that old line about doing the same thing over and over again expecting different results is insanity.

What does it mean for the Average Investor?

In the days following Yellen’s suggestion of the possibility of negative rates, we received texts and Facebook messages from some friends and families asking us if they needed to look into closing their saving accounts, in fear of being charged to hold money at {insert bank}. While we cannot absolutely rule that out, it seems things would have to get really, really, really dim for the U.S. economy for that to happen.  Although it’s worth noting that the average person is likely already being charged a net negative to hold their money at the bank through various charges, ATM fees, and so forth all while receiving little to no interest on their balances.  This is more of a discussion for central banks, however, not individual investors/savers (yet), per CNN :

“It’s the banks that are paying the penalty. The central bank is the “banker’s bank.” Banks deposit some of their funds there, much in the same way people put their savings in the bank.

When the central bank turns interest rates negative, it charges banks a fee to hold SOME of their money at the central bank. A JPMorgan analysis found that only about 2.5% of total bank assets are subjected to the penalty fee. It’s small, but meaningful. The intent is to spur banks to go lend more.”

What does it mean for the overall market?

So what could the unintended consequences be of more and more central banks implementing a once controversial policy – that was expected to be short term with manageable consequences – but  is looking more and more like a prolonged experiment?  Most people think it’s going to skew people’s investment decisions in a ‘reach for yield’ which could artificially inflate all sorts of different assets into bubble territory. Here’s Larry Fink of BlackRock:

“Their actions are severely punishing the world’s savers and creating incentives to reach for yield, pushing investors into less liquid asset classes and increased levels of risk, with potentially dangerous financial and economic consequences.”

While SocGen’s Albert Edwards was outspoken enough to say that we’re headed for disaster.

“In a research note he said central banks’ money printing programmes, known as quantitative easing, had made “virtually no difference to the economic recoveries other than to inflate asset prices, make the rich richer, inequality worse and make Joe and Joanna Sixpack want to scream in rage.”

While Doubleline’s Jeff Gundlach was quoted as saying it is a “horror” for global markets, continuing via CNBC:

Negative interest rates “are the stupidest idea I have ever experienced,” the newspaper Finanz und Wirtschaft quoted Gundlach as saying on its website on Saturday.

“The next major event (for financial markets) will be the moment when central banks in Japan and in Europe give up and cancel the experiment.”

Corporate Proof this doesn’t Work?

There’s a growing chorus pointing out that companies seem to the only ones pushing the stock market higher thanks to their ability to borrow money at very low cost.

Many large corporations have benefited from low rates in a different way than you might think. They have been able to access cash at a low rate, but what they are doing with the money is not being used to help their company or the economy. Corporations have issued record amounts of debt at very low interest rates, but instead of investing the money in R&D and capital investment, much of the borrowed money has been used for buying back their own stock and pushing their stock price higher. Others have raised money and gone into the M&A market buying up smaller competitors, but then consolidated staff resources because of redundancy. The actions do help the balance sheets look better but little has been done to increase actual economic growth.

Basically, companies are doing everything they can to have good earnings reports, to keep their stocks at a slow and steady climb. But that can’t last forever, and Fink says it’s something to worry about.

“In the U.S., the quality of corporate earnings is deteriorating, with record share repurchases in 2015 driving valuations — an indication of companies succumbing to the pressures of short-termism in place of constructive, long-term strategies.”

The Takeaway

The global economy is doubled down on the idea of QE, enough to play with fire and go with negative interest rates to spur growth. Pension Funds and Insurance Companies are large examples of investors feeling the pain of this growth experiment. This is largely due to their need to keep a large portion of their holdings allocated to bonds (which provide needed liquidity and consistent returns) but conflicts with the lower returns these bonds are offering. This has led to many finding it difficult to maintain performance benchmark objectives, thereby reaching for yield into riskier corporate and junk bonds yields – which drives their yields lower, forcing the search for yield to continue in a sort of negative feedback loop. It may also be the reason for more interest in alternatives such as managed futures – which operate outside the need for a certain interest rate or economic condition. Savers are also hoarding cash, with Central Banks now talking about eliminating large bills to make it harder to keep your money out of the system.  So there is a movement towards things which won’t be affected by negative interest rates, but none of them seem to be economic growth generating at this point, and they are becoming riskier and riskier for the same amount of yield.

There are not too many investments out there immune to the credit cycle and consequences of negative interest rates – so if you’re worried about what kind of risk your portfolio could carry, or worried if your “diversified” investments aren’t all that diversified to the domestic or global markets, we happen to know some pros in the Alternative Investment business. RCM Alternatives can tell you what’s under the hood, to prepare you for whatever is to come, with more negative rates or not. Give us a call at 855-726-0060 or email us at [email protected].

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