The topsy-turvy world of negative real interest rates presents investors with a number of challenges, as described in this article.

A number of countries have negative interest rates, creating strains for financial institutions. In this article, Paul Wiseman, senior investment analyst at Maitland, the global advisory and fund administration firm, delves into some of the specific elements of this situation and how asset allocation, for example, is affected. The views expressed here are not necessarily those of the editors of this news service and they invite readers to respond.

Global equity markets suffered a tumultuous start to 2016, with a confluence of factors seeing market participants hit the “risk-off” button. Amongst these factors was the continued decline in both growth and inflation expectations. As central banks have exhausted more traditional monetary policy tools, they have had to look to more unconventional methods to achieve their mandated goals. One such method is negative interest rate policies, which the central banks of Sweden, Denmark and Switzerland have all adopted for some time now.

On 29 January, the Bank of Japan surprised the market by introducing negative interest rates, in addition to its existing quantitative and qualitative monetary easing (QQE) programme in an attempt to achieve its price stability (inflation) target of 2 per cent. The European Central Bank followed the BoJ’s direction and announced the further easing of monetary policy on 10 March, which included a further cut in the already negative deposit facility rate to -0.40 per cent.

The very idea of a negative interest rate seems unnatural to most as the conventional notion of earning interest on cash balances has been turned on its head. What then, is the purpose of negative interest rates? In its simplest form, negative interest rates act as a deterrent to depositors for holding cash balances, by charging them for the privilege of doing so. The same applies to the banks themselves – central banks with negative policy rates are in fact charging the banks for holding excess reserves at the central bank. Both banks and consumers are therefore incentivised not to hold excess cash. Cash that is not held by consumers at commercial banks or by commercial banks at the central bank needs to be put to use elsewhere, and herein lies the key purpose of the negative interest rates set by the BoJ and ECB – to encourage consumers to spend and invest, and banks to lend (extend credit), in an effort to stimulate their respective economies.

While the rationale, mechanism and extent of interest rate policies can be complicated and vary widely across central banks, there are a number of generalisations that can be made.

Obviously, “cash” as an asset class becomes unattractive in a traditional sense as a guaranteed loss on a supposedly risk-free asset may not sit well with the average investor. A counterargument may be made that investors may be so risk averse that they are willing to accept this known and limited loss as opposed to a theoretically unlimited loss if they were to move up the risk spectrum. Indeed, a number of euro-denominated money market funds have returned cash to investors and closed as a result of investor preference for positive (or at least zero) returns. A rather unique phenomenon that exists as a potential counterproductive force is the possibility of banks, firms and consumers “arbitraging” against negative rates by hoarding cash. No evidence currently exists to suggest this is happening, but the possibility increases the more negative rates become.

At present, approximately $2 trillion of government bonds trade with negative yields. Holding such bonds to maturity guarantees a loss for the bondholder – bond mathematics still works with negative rates. Similar to the argument against holding cash, it begs the question as to why anyone is willing to hold such securities and lock in losses. Firstly, certain types of investors are required to hold these securities either by mandate obligation or regulation. Pension funds and insurance companies fall into this category. The liabilities of these types of institutional investors are typically matched with bonds, meaning these investors have to buy bonds regardless of their value as a result of solvency regulations. There are further complications relating to the effect negative rates have on the present value of these assets and liabilities, and therefore their funding positions.

Secondly, investors may take the view that the alternatives to bond investments (equities for example) may be too risky and the potential for large losses intolerable, making the smaller and limited losses on bonds a preferable proposition.

Lastly, investors may be of the view that deflation will materialise, making the real returns on bonds positive. Real returns should matter to investors, not nominal returns.

Equities and currencies also impacted
Further along the risk curve, equity investors are also impacted by negative interest rates. Equity prices should, in theory, benefit from lower rates as lower discount rates imply higher prices. It is also the intention of a negative interest policy to encourage risk taking with equities being a natural candidate. Increasing allocations to equity investments may also have the effect of supporting prices. Investors that see the value of their investment portfolios rise due to rising asset prices may feel a greater sense of financial security, causing them to spend more in a phenomenon known as the wealth effect. However, equity valuations derived from negative or even zero interest rates create the potential for “bubbles” to form. 

Valuations of stocks that seemingly offer current and prospective growth prospects may demand excessive valuations in a world where growth is scarce - hence the need for negative interest rates. Such stocks are often very susceptible to sharp sell-offs. Furthermore, if banks fail in their attempts to extend credit to consumers and businesses, further consumer spending and capital expenditure by businesses may slow, and with that, lower aggregate demand and growth in the economy. Both outcomes are potentially negative for corporate earnings and hence equities.

The currency markets are also impacted in a meaningful manner. As the interest rate differentials between two countries change, so does the relative value of the two respective currencies. Countries with lower interest rates generally attract less capital, driving the currency lower. Once again, this is true in theory but the reality can be somewhat different. In the days following the BoJ’s announcement in February to introduce negative interest rates, the Japanese yen in fact rallied over 7 per cent against the US dollar. While the time frame is somewhat short, it does highlight the fact that the resultant impact on markets is not always as theory would imply. The central banks of Switzerland, Sweden and Denmark have used negative interest rates as a tool to prevent appreciation of their currencies, to varying degrees of success. A weaker currency is desirable in the case of Europe and Japan, as this acts as a further loosening of monetary policy that may assist in igniting growth and rekindling inflation expectations.

The great unknown
It is important to note that the overall impact of negative interest rate policies is relatively unknown. The success of their intended outcomes can only be assessed in time while unintended consequences may manifest in the interim, many of which we simply do not know at this stage as feedback loops in the economy can be complex. 

However, it is clear that central banks are starting to see the marginal effects of their more conventional policies dwindling and more aggressive and unconventional tools are needed. We wait with anticipation to see if central banks can succeed in their mission to ignite growth and moderate inflation, as their monetary policy experiments continue to unfold.