When Interest Rates Go Underwater

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August 05, 2016


In the aftermath of the European debt crisis and the United Kingdom’s decision to leave the eurozone, several of Europe’s central banking systems have cut key interest rates to below zero.

 

Robert Haworth, Senior Investment Strategist for U.S. Bank Wealth Management, and Jennifer Vail, Head of Fixed Income Research for U.S. Bank Wealth Management, discuss the consequences of such moves and how they could affect the United States.

 

What are negative interest rates? How do they work?

 

HAWORTH: Negative interest rates are interest rates that are below zero.
 

Instead of earning interest on money deposited with banks, depositors are charged to keep their money in the bank. 

Central banking systems in Europe and Japan have cut deposit rates to below zero in the hope that this will encourage banks to lend more to each other, businesses and consumers and therefore boost the broader economy.

Negative interest rate policies’ goals include: inflation control, looser lending and economic growth. In what ways have they been successful?

 

VAIL: The efficacy of negative rates as a whole is still in question. For the most part, they’ve had the opposite of the intended effect. That’s why many central banks are reluctant to use them. 

 

HAWORTH: That’s clearly been the case in Japan and Europe. It looks like it worked OK with small countries like Switzerland, but even there it seems as though limits are being reached. Success has not really been applicable to other economies

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August 05, 2016


Are there signs that below-zero rates have begun to stimulate economies or reduce borrowing costs for companies or households?

 

HAWORTH: Maybe from a macro perspective, borrowing rates have come down. Overall, there isn’t much acceleration in loan growth. It takes about 12 months for [rate changes] to work their way through the economy. It hasn’t been that long since the European Central Bank (ECB) introduced its negative rate policy, so we’ll have to wait and see. 

 

VAIL: When a central bank executes a negative interest rate policy strategy, they’re hoping to weaken their currency, import some inflation and spur business investment. In larger economies, currencies have not yet weakened. Inflation has not yet moved upward. We don’t have enough data yet to point to success or lack thereof.

that have been using negative rate strategies for longer, it’s still not a long enough time for the data set to have any value. 

 

What are risks to financial institutions in these areas?

 

VAIL: The largest risk is margin compression. Banks do well when the yield curve is steeper. It enables them to pay a lower rate of interest on deposits and charge more on loans. Negative interest can be accompanied by a flattening of the yield curve as investors are forced to buy longer-dated bonds just to earn positive income.

 

HAWORTH: The second concern is about bank strength and stability. Negative interest rates may result in losses on deposits and undermine banks’ financial strength, driving them to increase the rates at which they lend — exactly what central banks don’t want. What the ECB was really trying to do was spur long-term investment in financing business operations. 

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August 05, 2016


Have the policies affected financial markets abroad?

 

VAIL: The sharpest reaction can be seen in the currency markets. The eurodollar was around 106 before the ECB went to a negative policy, and now it’s up over 110. In Japan, the situation is even more extreme. 

 

HAWORTH: Negative interest rates may also have been the biggest culprit in the underperformance of global bank stocks this year, particularly in Europe. Investors and banks have also been forced to wade into riskier investment products in a hunt for returns. Investors should note that equity securities are subject to stock market fluctuations that may occur in response to economic and business developments.

 

What are the implications for American investors and bond holders?

 

VAIL: There are very close ties between what’s happening overseas and what’s happening here

For the first time, the U.S. Federal Reserve has directly addressed global growth concerns in its public statements.

 

Domestically, negative interest rates abroad drive more foreign dollars into our bond market because our positive rate policy is more attractive to overseas investors. That pushes our yields down. When yields go down, prices go up. For now, that may be beneficial for existing bond holders. In the long term, all those foreign dollars invested in our market may unwind at some point. 

 

Investments in fixed-income securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term securities.

 

Investors should note that investments in fixed-income securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Investments in lower-rated and non-rated securities present a greater risk of loss to principal and interest than higher-rated securities.

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August 05, 2016


HAWORTH: In Europe and Japan —   two major global bond markets — rates offered for investment are much lower than U.S. Treasury rates for comparable maturities. Interest rates in Germany and Japan are near zero for 10-year maturities. Investors with longer-term investment horizons are receiving much less for these bonds in the negative-interest-rate environment than they had previously and may need to save much more to meet their savings goals.

 

Could a negative interest rate policy occur in the United States?

 

VAIL: The Fed has stated that it is not seriously considering any kind of negative interest rate policy.

Could negative interest rates be a long-lasting feature of the economic landscape? Do you expect ripple effects?

 

HAWORTH: Central banks will likely remain cautious in the wake of the United Kingdom’s decision to leave the European Union and could even push short-term interest rates further negative.

 

The biggest potential ripple effect is the long-term impact on the stability of financial institutions — now more acute given the Brexit referendum and its impact on global banks.

 

The debate on the efficacy of negative rate policies is still ongoing.

 

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