Download Negative Interest Rates – A Panacea?

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.
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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?
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