Negative Rates and an Upside-Down World

Topic: Investments

Devin Crago CFA

July 21, 2016

Image used with permission: iStock/StephM2506


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Negative Rates and an Upside-Down World

Negative interest rates don’t sound so bad when the result is getting paid to carry a mortgage.

Such is the reality for some borrowers in Denmark who, instead of paying interest on their mortgage loan, are actually receiving cash from their bank. In these upside-down times, Denmark provides an interesting case study. The Danes have had negative benchmark rates for about four years, which provides enough of a window to highlight some of the unintended consequences that can accompany negative rates. According to the Wall Street Journal:

“Scandinavia’s experience has given economists a chance to study what happens when rates drop below zero — long considered an inviolable floor on rates. Already, there are concerns about undesirable side effects. Consumer savings accounts pay no interest, and there is pressure on bank profitability. A boom in real-estate borrowing has kindled fears that problems will arise if rates bounce back up. 

‘If you had said this would happen a few years ago, you would have been considered out of your mind,’ said Torben Andersen, a professor at Denmark’s Aarhus University who serves on the government’s economic-advisory council. Authorities in both countries [Denmark and Sweden] are concerned that low rates have caused households to gorge on loans that they won’t be able to repay if rates increase or real-estate values fall. ‘It’s dangerous,’ Riksbank governor Stefan Ingves said in an interview. ‘Our households are borrowing way, way too much. It must be reversed sooner than later.’” 1

Negative rates around the world – a growing phenomenon

The arrival of negative rates is not exclusive to Scandinavia. In fact, JP Morgan recently observed that a remarkable 36% of all government bonds in the developed world had negative yields. Not only is that an astounding figure in its own right, but it becomes even more so when you consider that there were almost no bonds with negative yields just two years ago. The rapid spread of negative rates is breathtaking.

What does it mean for investors? Today an investor in 10-year German Bunds, in effect, must pay 11 basis points to lend the government money (e.g. theoretically, they pay $1.10 per year for every $1,000 investment in a 10-year German government bond).2 Compare that to the average over the last ten years, when investors were rewarded with a positive yield of 2.6% ($26 per year). In essence, investors have gone from earning $26 per year to paying $1.10 for the privilege of parking their money with the German government. No wonder there is so much interest in Canadian and U.S. bonds, which yield well over 1% for similar maturities.

The North American approach – “wait-and-see”

In Canada and the U.S., negative rates haven’t been ruled out, despite concerns from well-regarded experts over their long-term consequences.3 Canada’s central bank governor Stephen Poloz stated late last year that using negative interest rates is an option the Bank of Canada could consider. More recently, Fed Chair Janet Yellen acknowledged that the Fed does have the legal authority to use negative rates, although it has no intention to use them at this time. Yet, the incentive for central banks to push rates below zero exists, under the theory that low interest rates lead to higher asset prices and greater reinvestment in the economy.4

For better or worse, the U.S. approach to raising or lowering rates has been to become “data dependent”. This means it will act only when there is sufficient evidence that the fundamentals of the economy support a rate move. What’s the value in waiting? We find some insight in the writing of economic historian Peter Bernstein, who invokes Shakespeare to describe the potential value in hesitation:

“Hamlet complained that too much hesitation in the face of uncertain outcomes is bad because ‘the native hue of resolution is sicklied o’er with the pale cast of thought… and enterprises of great pith and moment… lose the name of action.’ Yet once we act, we forfeit the option of waiting until new information comes along. As a result, no-acting has value. The more uncertain the outcome, the greater may be the value of procrastination. Hamlet had it wrong: he who hesitates is halfway home.”5

This appears to be the philosophy of the U.S. Fed for the moment. Only time will tell whether waiting to raise rates will prove to be the correct decision, or whether holding rates low will lead to bad unintended consequences. Perhaps the only certainty is that a world of negative nominal rates is unprecedented and no one knows (yet) what the implications will be.

1. The Wall Street Journal April 14th, 2016.
2. Technically, an investor does not “pay” the government in the conventional sense. The mechanics of negative yields are such that if a bond has a low coupon and an investor pays a premium to face value at the time of purchase, the yield to maturity on a bond can work out to be negative. Essentially, under certain circumstances it is possible that the investor ends up with less money when the bond matures than the amount initially invested.
3. One voice worthy of attention is Jim Grant, who makes some excellent points on the risks of negative rates and radical monetary policy in his July 1, 2016 edition of Grant’s Interest Rate Observer.
4. For another excellent discussion of these ideas, we recommend NYU professor Aswath Damodaran’s March 11, 2016 blog post “Negative Interest Rates: Impossible, Unnatural or Just Unusual”.
5. Peter L. Bernstein, Against The Gods: The Remarkable Story of Risk, John Wiley & Sons, 1996.

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