In the US, we haven’t yet had to experience a significant period of negative nominal interest rates. But given economic fears and the extreme stimulus measures currently underway in Washington, negative rates on US government bonds could soon become a reality.
In the following paragraphs, we hope to shed light on what negative rates signal as well as how they might impact your investment portfolio. Finally, we will highlight opportunities that such a state of affairs might present.
Nominal versus Real
Sometimes it seems like the only thing “normal” about the last two decades of financial history has been the surge in unprecedented innovations. When we begin experimenting with the basic structure of financial markets, however, there are always unintended consequences. Now that people are talking about negative rates (or even experiencing them, as in Europe and Japan), we need to clarify what we’re talking about.
The “nominal” interest rate on a bond is the stated percentage that must be repaid each year to the buyer. Almost always throughout history, this number has been positive, because the bond buyer (i.e., the lender) expects some financial compensation for taking on the risk of lending the money and losing use of the money for some period.
By contrast, the “real” interest rate takes into account the inflation rate of the period of the loan. Real rates have often been negative for savers, though they might not have realized it at the time because of positive nominal rates. For example, a bond paying 2% per year in an environment of 2.5% inflation has a negative 0.5% real rate—the bond buyer lost 0.5% of purchasing power relative to inflation. But on the surface, that bond was making 2% per year for the investor.
Real returns on short-term US Treasury bonds usually stay close to zero and occasionally dip into negative territory. (Bank savings accounts usually pay even less.) Savers sometimes prefer keeping a stable purchasing power rather than taking on risk to outpace inflation. For such investors, short-term, high-quality bonds can make sense in moderation, although we would caution someone with a long investment time horizon not to play it too safe. Long-term, other kinds of assets have shown great potential to outpace inflation.
The Flip to Negative Rates
Given already historically low interest rates, how do you use the traditional rate cut tool to give the economy a boost? Well, currently the highest levels of government have been discussing negative policy rates to help stimulate additional spending and economic activity.
A negative overnight lending rate for banks would mean that the lender, not the borrower, was paying interest! Your checking and savings accounts, etc., would quickly follow suit, effectively penalizing you for saving money.
Why would the government flip rates like this? What are they hoping to gain? The below paragraph from a 2015 article by John Rubino presents the expectations. Note, however, that the reality has been very different.
Traditional economic theory says that a combination of massive deficit spending and historically low (not to mention negative) interest rates should produce a rip-roaring boom in which workers get generous raises, prices spike, and interest rates follow. Theory also says that, even in the rare case of nominal interest rates turning negative, the rates can’t stay there because beyond this “zero bound,” savers and investors will withdraw their cash and store it themselves, emptying banks and crashing the financial system. (source: https://www.cfainstitute.org/en/research/cfa-magazine/2015/deep-undercurrents)
The Hit to Banks
Let’s consider how the condition of negative interest rates would affect banks and savers alike. Aside from the obvious difficulty in attracting consumer deposits with which to create loans, the repercussions of negative interest rates on the interest margin business, which is one of a bank’s most important sources of revenue, can be dramatic.
Negative interest rates would result in a direct decline in interest margins and, therefore, a decrease in profitability for the banks and other finance-related companies. Competition between the banks as well as the option for clients to hold liquidity in cash mean negative interest rates are not naturally passed on to individual clients, who have options (though see our comments about Europe, below).
While we intuitively expect low rates to mean lower mortgage and lending rates, this may not be the case for negative rates. In some cases, mortgage and loan rates might increase as a result of a lessened ability for banks to hedge interest rate risks due to the costs increases associated with these transactions. Banks will have to look at various lines of business to make up some of their losses.
The Hit to Savers
In a negative rate environment, those with the most negative outlook for the economy might “suck it up” and lose a guaranteed amount of money to avoid losing an unknown amount. This has been happening in some form Europe for several years. Others scramble to new products offering a modicum of interest, even if it means taking on additional credit or duration risk. (Duration risk refers to the risk of lending money longer-term than the shortest periods.) Maybe others will do what the government wants, which is to spend and invest for the long run, but this has not always happened.
For example, in the 2008 crisis, the US engaged in extreme quantitative easing (“QE”) measures to stimulate a recovery. This involved printing money and lowering rates. But rather than contribute to economic growth by consumer and investment spending, many recipients hoarded cash. Corporations bought back their own stock rather than pursue profitable new opportunities, as buybacks tend to boost stock prices, a key measure of management performance. This was only one unintended behavior produced by perverse incentives.
Market Repercussions and the Lessons from Europe
Rubino goes on to explain that when rates are negative, savers begin hoarding cash (rather than putting it into negative-yielding financial instruments). After all, if you can keep money “in your mattress” for free, why pay a bank a quarter percent to store it for you? The more stimulus recipients hoard cash, the more the government has to try to crack down on this behavior by, for example, controlling on how much cash a person can hold or use to pay for purchases at one time. Such measures were actually instituted in Switzerland, Denmark, and France in the past decade.
In theory, a different level of interest rates between countries can also impact a currency’s relative strength, with the higher exchange rate belonging to the country with the higher interest rate. This is because capital tends to shift toward the higher-yielding currencies and away from the lower-yielding currencies. Negative rates would potentially lead to capital flowing out of a country, further harming its economic prospects.
The reality of negative interest rates would also create uncertainty in the markets, and this can take on a range of different characteristics. Risk-based pricing becomes more challenging. Insurance companies get a relative competitive advantage over the banks in the mortgage lending business, and the prevailing scarcity of investment opportunities for institutional investors is further exacerbated, potentially affecting the long term sustainability of retirement and pension plans to meet their actuarial liabilities without tilting investment portfolios toward more risk.
Too Many Dollars
While economist Milton Friedman once famously said, “Inflation is always and everywhere a monetary phenomenon,” the current massive stimulus can actually prove deflationary. In the article referenced above, Rubino mentions that as Baby Boomers retire, they seek safety and may prefer guaranteed assets, even if these cost a small amount. Loans must also be repaid, diverting money from potential spending and investment into debt repayments. And the uncertainty injected into our financial system by untried new methods may discourage major investment by those who have the cash.
We have recently witnessed what uncertainty does to asset prices. The dislocations experienced in Q1 2020 took most of us by surprise. Now that the dust is settling, however, it’s time to pick through the rubble to find any gems left behind such as good assets that were sold indiscriminately in a panic.
Not Everything is Negative
While we think the financial markets would eventually adjust to the realities caused by negative interest rate policy, savers would find the adjustments far less comfortable once any price boost to fixed income investments with positive interest rates had cycled through.
If you depend on yield income from savings, now is the time to reconsider your portfolio positioning. Under a negative rate policy, we feel you should seriously consider equity investments to generate either dividend income or growth of capital which would be spent.
A massive stimulus such as the ones being discussed can impact markets in unexpected ways; still, relying on our experience with building and monitoring portfolios, we think we can identify areas of the market likely to benefit in the short- and long run so you can make informed choices.
Remember: “safety” must be considered relative to your goals. Holding an asset whose nominal value remains stable doesn’t mean you are safe from the risks of missing opportunities or losing purchasing power. Please give us a call today or click the below link to schedule a free “Second Opinion” review of your investment portfolio.