Negative interest rate policies are not new and are often being used to support a country’s economy and lift sluggish inflation. As central banks start to use this policy more, it is important to understand it as an economic lever. So, let’s take a look as some frequently asked questions.
Q: What does a negative interest rate actually mean?
A: Instead of earning interest on your deposit/investment, you pay interest on your deposit/investment.
In a bond world, a negative interest rate means that an investor pays a substantial premium over and above the face (par) value of a bond. Remember, bond yields are inverse to prices and therefore lower yields translate into higher prices (and vice versa). Yields that move into negative territory make prices rise even more, making bonds very expensive.
Q: Why are interest rates negative?
A: Because once you hit zero and need to cut further to stimulate the economy, there is only one-way. That is down.
Following the global financial crisis of 2008, central banks have lowered interest rates to all-time lows in an attempt to ignite borrowing that would ultimately promote economic growth. Denmark was the first country to cut rates into negative territory in 2012, the European Central Bank followed suit in 2014 and the Bank of Japan shortly afterwards.
Q: Who is buying negative yielding debt?
A: Many different market players, for different reasons.
Even an asset with such irrational characteristics manages to find a buyer. Here are a few reasons why there are purchasers of negative yielding debt:
- Safe haven status: For a start, by buying negative yielding debt, investors are willing to pay a premium because of the need for safe-haven properties and/or liquidity that government bonds provide. In times of extreme uncertainty they can justify paying an “insurance premium” to know with certainty that they will get their money back (albeit possibly less) in a crisis scenario because the central bank or government will bail them out.
- Momentum-based investors: These investors are betting on yields falling into even more negative territory. The only way to make money here is obviously from capital growth as holding the bond to maturity will result in a guaranteed loss.
- Cross currency hedging: Believe it or not, in August 2019, US dollar-based investors could buy 10-year German government bonds at -0.7% and hedge out the currency risk and end up with a yield higher than that of a US 10-year government bond. The reason for this, simplistically speaking, is that the short-term interest rate in the US is much higher than that of Europe.
- Passive investors: There is a large portion of “autopilot” investors, those investing in passive bond index funds or exchange traded funds. These flows find their way into global bonds markets, including negative yielding markets, as investors look to diversify their portfolios into safe-haven assets like bonds.
- Central banks: Government debt (and corporate debt in some instances) form part of the open market asset purchased as part of quantitative easing.
- Regulatory reasons: Insurance companies may be forced to buy negative yielding securities for solvency requirements, or pension funds may be mandated to hold a certain amount in government debt, which may inadvertently include negative yielding debt.
Q: Has negative interest rate policy been effective?
A: Evidence of the true positive effect of negative interest rate policy is still lacking.
When it comes to consumers, governments use zero or negative interest rates in an attempt to induce spending, but certain studies have shown that on aggregate people might actually save more because they have to compensate for not earning a return on their savings. This defeats the purpose of negative interest rates. And while the impact of negative interest rates is not necessarily sustainable, it could be argued that without these extreme policies things might have been worse off.
Q: Are negative interest rates sustainable?
A: The truthful answer to this is “who knows?”
This is yet another experiment concocted by global central banks. Negative interest rates are bad for banks. And without a proper banking system an economy cannot thrive. Banks need to take in deposits to be able to issue loans in order to make money. They essentially earn the difference between the interest rate they charge on loans and their cost of funding these loans (e.g. the interest they pay on deposits). The reality is, each monetary policy tool since the financial crisis has become more extreme but has been less effective.
Q: What does this mean for investors and markets?
A: Risk ends up being mispriced.
Interest rates form the basis of the discount rate from which all other assets are valued. In finance theory terms, using a negative interest rate as the risk-free rate in a model results in a fair value for a security being able to head infinitely higher. In reality, this is not true. Faced with a guaranteed loss from buying a negative yielding bond, investors are forced to seek returns in riskier parts of the market where yields are positive. In fact, in Europe there are even certain sub-investment grade or “junk” bonds trading at negative yields. This is a perfect example of risk being mispriced.
Q: What is the endgame?
A: Probably more intervention. Not only from central banks, but from government as well.
Soon, when there are no more monetary triggers to pull, we may start to see further involvement from governments in the form of fiscal spending.
Written by Mike van der Westhuizen, Citadel Portfolio Manager