Talk of negative interest rates has recently picked up following Janet Yellen’s response to a question on the subject addressed to the FED chairperson. She indicated in her response that while negative interest rates are not a current discussion point of the FED, the subject is not off the table for future consideration. Negative interest rates as a central bank policy tool are now being used in the Eurozone, Japan, and many other countries around the world. In fact, close to 1/3 of the non-U.S. short-term sovereign debt outstanding around the world is currently subject to negative interest rates.
So what are negative interest rates and why are they being considered as a policy tool by central bankers? Quite simply, negative interest rates occur when a fixed income investment is purchased, and if held to maturity, returns the investor less than they paid initially for the investment. Another way of looking at negative interest rate is to assume that your money will be returned to you at maturity less a “penalty fee” imposed by the issuer of the investment. This can occur either by policy, such as a central banker targeting a negative yield (or penalty) to their fed fund target rates, or it can occur through normal market trading activity. In the latter case government bond prices are bid up to a level in which the cost exceeds the total of the face value and all subsequent interest payments. Typically this excess demand for government bonds is initiated by central bank purchasing activity.
So who can be helped and potentially harmed by negative interest rates? As with any form of lower interest rates, savers are harmed, earning less interest on their funds and potentially paying fees just for the right to save their own money. Borrowers are rewarded with a lower cost to borrow funds. Banks, in general, are hurt, as usually their net interest margins fall and their profits decline. Said another way, bankers are being charged a fee to hold conservative funds rather than to loan them out to borrowers.
Thus, a central bank would impose negative interest rates on their economy in order to stimulate additional borrowing/lending activity hoping for a greater level of economic growth. History does not provide much in the form of empirical evidence that negative interest rates succeed in stimulating additional economic activity, as our experience with negative interest rates is very limited. Europe has imposed negative interest rates on their banks for the last 18 months with little if any evidence that economic activity is picking up.
If negative interest rates were to occur here one would expect this to happen in a period of low economic growth or a recession. One would also expect credit spreads to be wider as default risk increases during weaker economic periods. This may be partially offset by greater demand for credit related debt to avoid having to purchase negative yielding short to intermediate term government bonds. Nevertheless, negative interest rates should be viewed as a last option only after all other forms of fiscal and monetary policy have been exhausted.
Jim Bernard, CFA, is the Managing Director, Fixed Income at Ancora Advisors LLC a SEC Registered Investment Advisor. He is also a Registered Representative and Registered Principal of Safeguard Securities, Inc. (Member, FINRA/SIPC)
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