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Negative Interest Rates – A Panacea? May 2016 Mark McGlone President, Chief Investment Officer PNC Capital Advisors Martin C. Schulz, J.D. Managing Director International Equity The world’s central banks are in quandary: How to jump-start economic growth in a world where deflationary pressures have reigned supreme and politicians are timid. Interest rates have been on a downward trend for the past several years as debt, deflation, and demographics have combined to form a powerful cocktail, particularly in the developed markets. With economic growth not rebounding as expected and remaining sluggish, more and more central banks are wading into the negative-interest-rate arena – with decidedly mixed results. Negative interest rates are intended to force banks to lend and jumpstart economic activity and inflation, but so far, credit growth has been anemic. Where do we go from here? Naturally, consumers love sales. What can be more enticing than to see a sign promising 25%, 35%, or even 50% off the regular price? Who can resist the urge to splurge when we are offered a BOGO special: Buy one, get one free? It is simple economics, when the price of something falls, demand goes up – we want more of it because it costs less. Our delayed gratification defenses weaken and we reach out to buy when we hadn’t planned on it . . . Normally, in the world of economics and finance, the same holds true. If interest rates (the price of money) fall, buyers (borrowers) want more of it (loans) because it is cheaper. The borrower’s monthly payments are reduced because interest rates are lower and one can now afford a bigger house, a fancier car, or a bigger education via a loan all paid over time. Real estate developers can borrow more for a larger, new building investment; corporations can put more capital projects to work since the cost to finance them has dropped. The economy starts to perk up. Suppliers of funds (savers) have a different incentive. They want more interest and a higher yield. They want their money to work hard. It hurts them when interest rates go down. Think of the many retirees who were invested in bank CD’s when rates were 4%, 5%, or higher. A $100,000 CD paying 5% was generating $5,000 in income each year. Now with lower rates, maybe down at 1%, that same CD is only paying out $1,000 per annum – an 80% reduction in income! Falling interest rates are not friendly to savers. pnccapitaladvisors.com FINANCIAL REPRESSION: IT HURTS TO BE A SAVER This is a familiar scenario, as we in the U.S. have been living with low interest rates for quite some time. Since the global financial crisis (GFC) in 2008 and 2009, short-term interest rates in the U.S. have been close to zero and only very recently have moved higher ever so slightly. In the financial world, there is a term for this low interest rate environment that is enforced by central bank policy. It is called financial repression – the idea that the central bank is willing to penalize risk-averse savers with low (or no) yield, in order stimulate other areas of the economy by having A) those savers invest in riskier investments (longer maturities, dicier credits, volatile stocks, etc.) and B) borrowers hopefully borrowing more to buy cars, houses, equipment, factories, etc. because the cost to do so has fallen dramatically. In the U.S., we can say that this experiment in prolonged low interest rates has been modestly successful. Unemployment has been halved, cars have been selling at a pretty brisk clip over the past few years, and the housing market is on much better footing than during the crisis. Corporate profits have been healthy and stock price indices are generally near highs. GDP growth has been OK (but not great) and inflation has been tame. The medicine has generally worked and we have so far tolerated the side effects. But what happens when the medicine isn’t working? What do central bankers do when they lower interest rates to zero for a long time and the patient (the economy) doesn’t respond smartly? Well, in many areas of the developed world, we are seeing the experiment in real time. Central banks in the Eurozone, Japan, Sweden, Switzerland, and Denmark have all moved to lower interest rates below zero and into negative territory. NEGATIVE INTEREST RATES: IMPLICATIONS AND UNCERTAINTIES Long considered an unconventional monetary policy tool, negative-interest-rate strategies are now being utilized by some of the central banks of several advanced economies. The idea behind below-zero rates is straightforward: If commercial banks are required to pay for excess reserves held by central banks, these financial institutions would lend more US Dollar per Euro rather than be charged for idle deposits. 1.5 The desired result – as the thinking goes – is that a sluggish economy 1.4 would be stimulated by increased credit availability. Below-zero rates could also 1.3 help combat deflation and potentially boost exports by encouraging currency 1.2 4/28/2016 depreciation. Another side effect is 1.13 a cheaper currency, which helps a 1.1 country’s exports. 1.0 2012 2013 2014 2015 NEGATIVE INTEREST RATES: FROM UNORTHODOX POLICY TO IMPLEMENTATION — FX Rate – US Dollar Per Euro Source: ©FactSet Research Systems Yen per US Dollar 130 120 110 4/28/2016 108.56 100 90 80 70 2012 2013 2014 2015 — FX Rate – Japanese Yen per US Dollar Source: ©FactSet Research Systems 2 Negative Interest Rates – A Panacea? Denmark was the first country to implement a negative-rate policy in 2012 in order to address foreign exchange issues as the euro sank in value. The European Central Bank (ECB) became the first major central bank to go negative in 2014. The ECB has now cut rates three more times following the initial step and the deposit rate currently stands at - 0.4%. In addition, the ECB is continuing its quantitative easing stimulus along with making new fouryear loans available to banks at below- zero rates. Further, the ECB has added corporate bonds to the list of securities it is willing to buy in order to stimulate growth. Central banks in Sweden, Switzerland, and most recently Japan have further joined the negative-interest-rate club, resulting in almost a quarter of the world’s GDP now coming from countries pursuing this policy. The long-term impact of negative interest rates is not yet clear. In Europe, 40% borrowing costs have fallen, and yields 35% on many short- and intermediate-term 30% sovereign bonds have dropped below zero. In fact, over 20% of the Barclays 25% Global Aggregate Bond Index has a 20% negative yield and is approaching one 15% third of the European benchmark. Loan 10% growth in Europe has been sluggish, 5% although ECB statistics released in 0% late March showed that lending may 2011 2012 2013 2014 2015 2016 be picking up. More time must pass to — Barclays Euro Aggregate — Barclays Global Aggregate determine if this expansion in credit is Source: Barclays Capital sustainable. While there is no indication yet that lending in Japan has risen – the policy was just announced in late January 2016 – the yield curve on domestic debt has fallen, with bond yields out to 10 years having turned negative. Percentage of Index with Negative Yields RISKS AND CONCERNS While the goal of negative interest rates is to spur growth, there is a risk that the policy might do more harm than good – especially if it is pursued over the long-term. Importantly, below-zero rates create distortions in savings and investment behaviors, eroding long-standing disciplines and incentives. For banks, negative rates can narrow the net interest margin between lending and deposit rates, harming profitability and potentially causing them to be less inclined to extend credit. Financial institutions may take on greater risk in a negative rate environment in an attempt to garner higher returns, adding to their downside exposure. In addition, some non-bank financial institutions – especially pension funds and insurance companies that are a primary source of an economy’s savings – may struggle to meet their long-term liabilities when rates are low or negative. In the final analysis, credit availability alone does not produce growth: Central banks can create incentives for banks to lend, but they cannot make companies and households borrow. For investors, a falling rate environment is generally good for bonds in the near-term and positive for equities over the longer-term. However, negative interest rates are unsettling for asset allocation strategies and appear to be contributing to market volatility and uncertainty. As noted, banks and other financial institutions are under pressure in a sub-zero rate world and their shares are paying the price for it. Further, if more and more central banks use negative rates as a stimulus tool, the policy could lead to increasing rounds of ineffective competitive currency devaluations. And the last thing the current, sluggish global economy needs is a currency war. A DIFFERENT PATH IN THE U.S. Conditions in the U.S. have not led policymakers to a policy of negative interest rates. In fact, the U.S. Federal Reserve Bank (Fed) announced in December 2015 that, after seven years of historically low interest rates, it planned to raise rates to higher and more normalized levels. U.S. private sector lending is increasing, the labor market has improved considerably since the recession, and domestic economic growth, while not robust, is stronger than in Europe and Japan. That said, recent market turmoil and heightened global economic uncertainty have caused the Fed to put the brakes on rate increases for the time being. In February, Fed Chair Janet Yellen told Congress that the Fed has not ruled out imposing negative interest rates if the economy takes a downward turn. Minutes from the most recent Federal Open Market Committee (FOMC) meeting indicate the Fed is likely to remain flexible in the timing of the 3 Negative Interest Rates – A Panacea? next rate hike. At the same time, the Fed’s 2016 scenarios for bank stress tests included the potential for short-term Treasury rates to fall to negative levels as part of the “severely adverse scenario.” Still, FOMC Chairman Yellen said she does not expect the economy to slow enough to cause the Fed to cut interest rates, let alone initiate a sub-zero policy. MONETARY POLICY IS NOT ENOUGH Monetary policy has borne the responsibility for stimulating expansion almost single-handedly over the last several years since the GFC. Politicians have not had the will. In an attempt to step into the breach and promote growth, central banks have used a combination of conventional and unconventional policy tools to push down interest rates and encourage lending. However, the outlook for the world economy remains sluggish: In April, the International Monetary Fund announced that it had once again reduced its forecast for global growth prospects, its fourth straight cut in a year. German Budget Deficit as a % of GDP 2 1 0 -1 -2 -3 -4 -5 ‘00 ‘01 ‘02 ‘03 ‘04 ‘05 ‘06 ‘07 ‘08 ‘09 ‘10 ‘11 ‘12 ‘13 ‘14 ‘15 Source: Eurostat, Bloomberg U.S. Budget Deficit as a % of GDP 4 2 0 -2 -4 -6 -8 For good reason, faith that monetary policy alone can trigger growth is diminishing. Global central bankers in advanced economies are calling for help in the form of more aggressive fiscal policies. Several European countries – most notably Germany – have the capacity to finance deficits, take on debt, and increase public spending. The case for locking in cheap long-term funding today to make long-term investments is a compelling one. Unfortunately, Japan has less fiscal flexibility than Europe and the U.S., given its aging population and extraordinarily high ratio of government debt to GDP. But both Japan and Europe have significant opportunities to improve competitiveness and productivity by liberalizing markets and taking on entrenched special interests. WHERE DO WE GO FROM HERE? -10 Negative rates are neither a panacea for stimulating growth nor a costless ‘00 ‘01 ‘02 ‘03 ‘04 ‘05 ‘06 ‘07 ‘08 ‘09 ‘10 ‘11 ‘12 ‘13 ‘14 ‘15 exercise in monetary policy. In finance, Source: U.S. Treasury, Bloomberg lowering the cost of an item (borrowing) usually sparks demand. However, when interest rates go negative as they have now in several countries around the world, the usual incentives are distorted. At the present, consumers’ deposits have been shielded from negative rates, but should central bank policy stay negative for longer, banks may be forced to pass on those costs to consumers. Then, one may see consumers taking cash out of banks and stuffing it in the proverbial mattress in order to avoid the cost of deposits – a type of financial disintermediation that the central banks and our system of economic governance would like to avoid. -12 In short, monetary policy has been shouldering the load for so long that investors have become too reliant on the next policy from central banks to keep economies moving forward. Like most powerful medicines that are used for an extended period of time, it begins to lose its efficacy. We believe it is the time for the developed world governments to include fiscal stimulus and structural reform tools to ramp up growth and let monetary policy move back toward normalization. 4 Negative Interest Rates – A Panacea? Negative Interest Rates – A Panacea? This publication is for informational purposes only and reflects the current opinions of PNC Capital Advisors, LLC. Information contained herein is believed to be accurate, but has not been verified and cannot be guaranteed. Opinions represented are not intended as an offer or solicitation with respect to the purchase or sale of any security and are subject to change without notice. Statements in this material should not be considered investment advice, a forecast or guarantee of future results. To the extent specific securities are referenced herein, they have been selected by the author on an objective basis to illustrate the views expressed in the commentary. Such references do not include all material information about such securities, including risks, and are not intended to be recommendations to take any action with respect to such securities. Securities identified do not represent all of the securities purchased, sold or recommended by PNC Capital and it should not be assumed that any listed securities were or will prove to be profitable. 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