09/10/19

Negative Interest Rates: Quo Vadis?

The European Central Bank (ECB) first entered negative interest rate territory in June 2014, while the Bank of Japan (BoJ) followed suit in January 2016. Negative interest rates, once a mythical concept, have not only become more commonplace across advanced economies but have seemingly become entrenched as the global growth outlook fades. An indication of this is that these negative rates, at one time only the arena of central banks and thereafter sovereigns, have now entered the domain of corporate non-investment grade debt.

At the end of 2018, global negative-yielding debt amounted to US$8.3 trillion and has since grown by 104.8% over the course of this year, to total US$17.0 trillion by the end of August 2019.

Source: Bloomberg

Traditional banking operations pay savers interest on the money deposited in their vaults. Banks use these deposited funds to extend loans to other customers. However, during weak economic and low inflation periods, we’ve seen interest rates in advanced economies set at or below 0% in an effort to stimulate growth, hoping to avoid deflation and economic stagnation.

During deflationary periods, because prices are expected to go down, individuals and business opt to forego current consumption and rather save more in order to improve their consumption abilities in future (when prices are expected to be lower). This can exacerbate economic stagnation, as consumption forms one of the four components of our GDP calculation. Central banks thus turned from interest rates at zero to negative interest rates, in theory ‘punishing’ banks for holding money as opposed to extending loans and advances – which would spur consumption, thereby driving up economic growth and inflation.

The situation has now extended beyond central banks and already exists in the sovereign debt market, where both the Netherlands and German yield curves are fully negative. This means that, as an investor, if you lend money to either of these two Governments, they intend to pay you back less money – even for repayment (maturity) dates as far out as 30 years from now.

An important factor that led to this phenomenon was the prevalence of historically strong liquidity. The strong liquidity positions arose from unconventional methods, namely Quantitative Easing (QE), undertaken by central banks to avoid economic and financial crises in their economies.

QE is a method whereby central banks increase the supply of money by buying financial securities, such as government bonds. The reasoning behind this was that the increased liquidity in the banking system would see banks extend more loans and advances, and spur more consumption within their economies (very similar to the reasoning behind negative nominal interest rates). The increase in money supply lowered the cost of funding (for banks, corporates and sovereigns), as the abundance of liquidity meant increased demand for securities such as bonds, thereby driving down interest on these securities.

The advent of QE, and subsequent liquidity, is illustrated in the balance sheets of the three major central banks, namely the Bank of Japan, the Federal Reserve (FED) and the European Central Bank. Since 2008, the balance sheets of these three central banks have seen extraordinary growth since the implementation of QE.   

Source: Bloomberg

Quite simply, QE did not have the desired long-term effect. Inflation in the Eurozone and the US remains stubbornly low, while Japan battles deflation. Strong economic growth also didn’t last long, with current fears of a global slowdown starting in advanced economies. Central banks therefore turned to what policy they had available – interest rates (a.k.a. ‘repo rates’). This does not appear to be enough to stem slowing growth and drive consumption, although combined with QE has provided extremely cheap funding for some governments, even making it logical for them to run large deficits as they repay less than what they initially borrowed.

The sustainability of negative central bank rates remains in question, as well as how deep into negative territory the banks can and are willing to go. Previously, commercial banks held off on passing these rates to consumers, however with the rigidity of these negative rates retail banks have begun to shift the burden to their customers. Bloomberg reported that a growing number of German banks are passing on negative interest rates to their retail customers as the costs become too high to bear on their own. Moreover, Berliner Volksbank, the country’s second-largest co-operative lender, started to apply a -0.5% rate on deposits exceeding €100,000 ($110,000) in its first charge to retail clients. Denmark’s third largest bank, Jyske Bank, recently began issuing ten-year mortgages at rates below 0% – meaning the bank is essentially paying you to buy a house.

Source: Bloomberg

Lower (near zero) or negative interest rates do not have a direct bearing on developing and emerging markets, but they do allow these other markets (Namibia included) to keep their own policy rates lower than what has been the case historically. From 2009 until 2015, the FED has kept its policy rate at historically low levels, allowing the SARB to push rates lower and seeing the Bank of Namibia keep its repo rate at historical lows. This played a role in Namibia’s strong economic expansion in the first half of this decade, but it could be argued that such low interest rates in our economy were inappropriate given the strong growth levels. While negative interest rates are not expected to make their way to our shores, lower interest rates typically mean a lower return for those with deposits, but also that funding (credit) can be extended at lower rates.

Negative interest rates remain a phenomenon limited to advanced economies, at least for the foreseeable future. The practice still raises more questions than it can answer, such as how long can rates be kept negative, how far into negative territory can they go, and what happens if rates move back into positive territory? Frankly, we are in relatively unexplored territory for monetary economics with the prevalence of negative interest rate policy and the recent re-introduction of QE. However, for us in Namibia, negative interest rates are a far-off concept for distant lands.