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Fixed-Income Insights

Major central banks have adopted negative interest-rate policies (NIRP) in hopes of boosting economic growth. What possibly could go wrong?

 

In Brief

  • While the rationale for negative interest rates is appealing on many levels, reality suggests that there may be different, less appetizing consequences for countries pursuing the strategy.
  • First, with prospects for future growth dim in the eurozone and Japan, loan demand may not increase, regardless of the price or how much incentive banks are given to lend.
  • Second, central banks may find that if negative short-term rates promote investor interest in longer maturities, the yield curve could flatten, not steepen, potentially decreasing bank profitability.
  • Finally, the currency weakness produced by a negative-rate strategy may force competitive devaluations among global economies.
  • The key takeaway—Central banks will monitor the consequences of negative rates before they reverse their decisions, upon which the global financial infrastructure depends.

 

Second of three parts.

It seems that central banks increasingly are embracing negative interest rates as a potential solution for feeble economies and low inflation. As we noted in the first article in this series, Japan recently joined Sweden, Switzerland, Denmark, and the eurozone in pursuing a negative interest-rate policy (NIRP) in hopes of stronger economic growth, and higher inflation, in part through a weaker currency. On February 11, 2016, for example, Sweden’s central bank responded to other “central banks pursuing more expansionary monetary policy” by lowering its key interest rate farther into negative territory in order to keep its currency, the krona, from appreciating and, subsequently, saving the economy from deflation. 

While investors have feared a devaluation of the yuan by China that could spark a “race to the bottom” among emerging market currencies, which in turn would curtail global growth, developed countries (other than the United States) have pursued the same strategy via negative rates. Even greater negative rates are expected. European Central Bank (ECB) president Mario Draghi’s promise in January that there is “no limit” to monetary policy efforts to increase inflation stoked expectations for further negative-rate adjustments in March. Poor currency response to NIRP in Japan suggests to many observers that additional negative adjustment will be forthcoming there as well.

Accentuate the Negative
Central banks’ infatuation with negative rates seems rational, on the surface. Negative rates on excess reserves theoretically give banks the incentive to lend funds at an attractive rate, thereby reducing expensive excess reserves and increasing loan-related income. Negative short-term interest rates also should steepen the yield curve, which would be a profitable development for banks that should further promote bank lending. To the extent negative rates are transmitted to other investments, investors are induced to seek other options, either by taking on greater investment risk or by taking their money out of the NIRP-affected country altogether. 

By seeking other options, borrowing costs for other credits can be reduced, promoting additional borrowing and attendant economic growth. In the process of seeking other investments, to the extent funds leave the country, negative rates essentially depreciate the exchange rate, promoting growth through cheaper exports and inflation through more expensive imports. 

NIRP seems like monetary policy panacea, capable of addressing all core issues facing slow-growth countries. No wonder it is so popular among central banks.

Unintended Consequences
While the rationale for negative interest rates is appealing on many levels, reality suggests that there may be different, less appetizing consequences. With prospects for future growth dim in the eurozone and Japan, loan demand may not increase regardless of the price or how nudged banks are to lend. So much, then, for reducing expensive excess reserves and increasing loan-related income. And if negative short-term rates promote investor interest in longer maturities, the yield curve could flatten, not steepen, potentially decreasing bank profitability. 

That last factor may already be at work among the NIRP adopters. Note the relatively flat yield curves in NIRP countries, where negative interest rates extend to five-year maturities in most countries and even to 10 years in Switzerland and Japan. Investor interest in higher-yielding, riskier securities reduced yields for a while, but recent concerns about global growth have reversed that phenomenon; credit spreads have gapped well beyond historical averages. 

Finally, negative rates may produce currency weakness if other countries don’t respond in kind. But as Western nations reminded China after its depreciation of the yuan last summer (via a more traditional method of adjusting the currency’s value versus the U.S. dollar), the advantage is immediately lost when competing countries respond with similar policy. Currency wars produce no country advantage, only collective loss.

Supplying Demand?
It may be that a negative interest-rate policy is designed to ignite demand that does not actually exist. The arrival of the NIRP concept comes after seven years of protracted low interest rates, which likely has fulfilled all demand to finance viable projects. The attempt to arm-twist banks to lend more seems destined to fail, especially since borrowers already have financing, and that expectations of continued slow economic growth suggest overcapacity, not the need to invest for expansion. Indeed, recent corporate borrowing seems increasingly aimed at financing mergers and acquisitions, a strategy designed to gain efficiencies more than promote growth. What is left in the way of loan demand may derive from those borrowers and projects that once were deemed unreliable or too risky. If this is the case, NIRP may come across as central banks’ attempts to promote expansion by reducing credit standards, which ultimately may be seen as an act of desperation. And just as bad, such a policy would appear to be the antithesis of years of efforts by regulators and central banks to improve bank balance sheets.

If there is little loan demand and the remaining financing requests involve additional credit risk, perhaps some economic benefit of NIRP could be found in refinancing existing debt. Here, too, policy may be too late, and may have unintended consequences. Corporations, local governments, and individuals have had opportunities to refinance higher-rated debt at lower, less expensive levels. Negative rates may create that opportunity again, but it does nothing for bank profitability. More broadly, replacing existing loans with slightly lower rates in the hopes that lower interest costs will somehow stoke additional business spending seems an uncertain outcome, given expectations for weak global growth.

Negative interest rates may occupy some role in monetary policy, but with today’s absence of loan demand, NIRP may prove at best ineffectual and at worst damaging to a country’s financial infrastructure. Without loan demand, NIRP can impair bank profitability if the costs of bank reserves are increased and banks are unable to pass on negative rates to depositors (indeed, it would be difficult to imagine bank ads touting sub-zero interest rates on savings accounts). Lower profitability may ultimately reduce bank credit quality as rating agencies take into account banks’ diminished capacity to service debt, at some point increasing bank financing costs. Such a serial effect could make lending more restrictive—which would be a consequence opposite the original intent of NIRP to make loans more available.

Summing Up
If negative rates are transmitted to bank deposits and other fixed-income investments, unfolding as it is in the eurozone and Japan, the consequences could become severe. Imagine, for example, sustained negative rates on government debt, then corporate debt—soon the viability of insurance companies and retirement plans would become questionable. One solution to avoid such consequences and increase the potential success of NIRP is increased loan demand via fiscal policy that involves infrastructure building, investment incentives, or tax reform. Absent such fiscal initiative, let’s hope central banks monitor the consequences of negative rates before they reverse their policy decisions upon which global financial infrastructure depends.

Next: The potential impact of NIRP on investments.   

 

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