“Can I Borrow a Dollar?”
No–I’m not kidding.
…alright, so maybe I’m blowing the point out of proportion, but the fact of the matter is: the world is beginning to pay for the “opportunity” to park their money with central banks. But what does that mean, and why is it strange?
To bring it back to basics, interest rates are–in simplest terms–the cost to borrow money. From the lender’s perspective, it’s the premium they receive for lending out their money to others. What happens, however, when the lender (the investor) doesn’t get a premium, or even loses money? Well, that’s the situation in the European Union, Japan, Denmark, Sweden, and Switzerland right now–dating, for some, back to 2014–but why would investors take the deal?
Developed governments and, by extension, their central banks, are generally seen as having low default probabilities (depending on their financial health/political sanity). The U.S. Government and Germany, for example, are seen as having “zero default risk,” meaning that they are safe countries to place your money in (a.k.a. buying their bonds). Post-recession, as some still feel nervous about the equity markets, investors are turning towards these safer investments. With little options for “risk-free” investments (as well as tax benefits of staying within the country), investors feel as though they are better off losing a small percentage of their investment rather than the risk of losing their entire principal.
As for the central banks, what reason do they have for bringing-in negative rates (other than the face value of generating cash-inflows)?
Simply put, there is a school of thought that, by effectively ‘charging’ for deposits, it encourages commercial banks to use the money elsewhere, thus fueling the economy. But how does it all work? The central banks of nations have a lot of different tools that they use in an attempt to make the economy move they way that they want it to. One such tool is declaring a change in the interest on excess reserve deposits. Commercial banks are required to keep a certain amount of reserves with the central bank in order to ensure the bank’s safety, but the banks usually hold a significant amount of money over and above those requirements, called excess reserves. Conventionally, these excess reserves earn interest while on deposit, which gives commercial banks a choice of whether they want to keep their money in the “safest place in the world,” but at a relatively low interest rate, or if they want to “lend it out” to riskier (and possibly more profitable) investments. These rates are the basis for the interest rate at which commercial banks lend money to each other to help meet reserve requirements, as well as the interest rate of sovereign debt securities, like the German 10 Year Bond, which serves as Europe’s benchmark bond.
With the resurgence of negative rates (since their last appearance in the 1970s), central banks are trying to incentivize commercial banks to put their excess reserves back into the market in order to grow the economy. More specifically, when commercial banks turn away from these negative yield investments and put the money to use by lending it to businesses for expansion, individuals for mortgages, etc., they help to jump-start the economy from the ground up. The “jump-start” (theoretically) is a rise in inflation, bringing about a rise in consumer prices and, thus, a rise in corporate profits that can be redistributed into the economy through taxation, new hires, expanded operations, etc.
On paper, it seems to make sense, but then why are all governments not adopting it; and how successful has it been in the countries who have adopted negative interest rates? Well, to start, the economics of investing can be boiled down to the simple idea of rational choice: if there are many options on the market, a rational investor will choose the option that is most beneficial to them. In the case of negative interest rates, investors will not inherently choose an investment that will make them lose money–instead, they will look for profitable investments at their given risk tolerance. If an investor is looking towards government securities in order to avoid large amounts of risk, they will look at comparable securities to their country’s negative bonds and likely move their money to a foreign country. When investors choose to convert their sovereign money into a different currency, it causes a decline in the strength of their domestic currency. Take, for example, the Swiss franc. The Swiss National Bank has also introduced negative interest rates (although, not for the first time), but has been intentionally keeping their rates lower than those of the European Central Bank so the franc is weaker, potentially boosting exports to the European-bloc.
A second consideration of the detriments of negative interest rates is the ‘squeezing’ of bank net interest margins (the interest payments they receive on loans, less the interest they pay out to depositors). By imposing a ‘tax’ on excess reserves, central banks are forcing commercial banks to give lower and lower interest rates to their depositors. In a perfect world for the banks, they would prefer to have their own interest on savings accounts be “more negative” than the rates they are charged by the central banks so that they can have greater interest margins. However, since investors are thought to be rational, they would not fall victim to negative deposit rates, preferring to buy a bigger mattress to stash their money rather than keep it in the bank. Therefore, banks are keeping their rates positive, but are sure to keep them as low as they can.
Possibly the biggest reason as to why negative rates have been shunned is their horribly negative connotation among investors. The fixed income market has been in such a tremendous bull market for the greater part of the last three decades and hearing that it is turning bear deals a huge blow to investor confidence; in the eyes of the average investor, negative rates seem desperate.
However, with five central banks already having adopted negative rates, what hope do these countries have of positive results? As with any economic theory, there is a great deal of skepticism; skepticism that has been supported by data from countries who have adopted these rates–especially the lackluster performance in Japan. In July, Japan saw a 0.5% decline in its Core Consumer Prices–the exact opposite of the intended effect. The Eurozone, on the other hand, is close to their goal of 2% rise in inflation each year, but still lagging behind at an annualized 1.8% in Q2 2016.
In the U.S., we continue to hope for a rate hike in December, but Federal Reserve Board Chair Yellen has hinted at the possibility of bringing rates negative, which begs the question: can I borrow a dollar?