The Downside of Negative Interest Rates

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By Charles Tan - September 2019

The once-abnormal concept of negative interest rates/negative-yielding bonds is now the norm in many markets, including Germany, France and Japan. Negative-yielding debt has been steadily increasing throughout the world, and currently, approximately 25% of developed-markets investment-grade bonds have negative yields.

Against a backdrop of slowing global growth, muted inflation and dovish central bank policy, many investors worry the U.S. won’t remain immune from this dangerous bond market anomaly.

A World of Money for Nothing

In a normal bond market environment, in which we believe yields are positive, bond issuers, including governments, make interest payments to investors who lend them money. In an abnormal, or negative-yield environment, investors essentially pay the bond issuer to hold their money. So, in Germany for example, financial institutions must pay the European Central Bank (ECB) to hold their reserves.

As central banks around the world battle stubbornly low inflation and sluggish growth, they are betting that negative interest rates are the remedy. Policymakers believe negative yields will encourage financial institutions to lend or invest their reserves rather than deposit them with the ECB and lose money.

While the strategy may seem sound, we believe negative rates represent an ill-conceived policy with significant risks for global economies.

Central Banks Face an Uphill Battle

In addition to weak growth and inflation, other issues have helped drive yields into negative territory. Aging populations, excess savings rates and, most important, rapidly rising debt levels around the world also are key culprits.

Monetary policy is unable to fix the long-running, secular and structural trends facing world economies. For example, interest rate changes won’t solve the economic and social problems stemming from aging populations.

Policymakers have three possible ways out of the mounting problem of soaring government debt: growth, inflation or default. Two alternatives represent burdens on savers, either by decreasing purchasing power (inflation) or eliminating returns (default). This leaves growth as the ideal solution.

However, when a decade-long ultra-low interest rate environment didn’t spark economic activity, policymakers set their sights on negative interest rates as a potential new solution to boost growth and inflation and ultimately reduce debt levels. The result so far of this unprecedented monetary experiment has not only been disappointing, we believe it has serious long-term consequences for economic and financial stability.

The Negative Rate Experiment Yields Disappointing Results

Central banks in Japan and Europe have kept interest rates negative for nearly five years. They’ve also purchased approximately $20 trillion in government bonds and other securities via quantitative easing (QE). Despite these significant and unprecedented efforts to promote growth and inflation and reduce debt levels, global growth remains lackluster, global inflation remains muted, and global debt remains massive and multiplying.

To date, negative rates have failed miserably in achieving growth and inflation goals, even before considering their long-term side effects to the economy and debt levels. And the ECB just doubled down on this policy with another rate cut. Japan’s central bank also has announced it will cut rates further into negative territory, if growth and inflation remain weak.

Damage Will Be Slow and Severe

We believe negative yields pose an existential threat to our long-standing financial and economic systems by ultimately transferring wealth from savers to debtors. They punish savers, who lose money on their deposits, and they reward debtors, who essentially get “paid” for borrowing money. This undermines the entire premise of our banking systems and financial markets.

Negative rates also distort capital allocation. When high-yield debt trades with negative yields, as is happening in parts of the European high-yield market, it’s an indication price discovery has broken down.

We do not believe the outcome will be like the explosive, immediate type we witnessed with the collapse of Lehman Brothers and other firms during the financial crisis. Rather, negative rates are like termites that slowly hollow out our banking system, erode pension plans and insurance companies, and eventually destroy income and wealth. The damage from negative rates is more pervasive and insidious, permeating throughout financial markets and the economy to touch every-day life.

The U.S. Isn’t Immune

It’s the $1 trillion question: Will the Federal Reserve (Fed) head down the path into negative rates? Unfortunately, we think it eventually may. Trade tensions continue to drag on, growth is slowing, and inflation remains stubbornly low and below the Fed’s target. Longer-maturity U.S. Treasury yields have plunged to multi-year lows and below their shorter-maturity counterparts. In response, the Fed may continue cutting short-maturity interest rates—even past zero if the yield curve doesn’t steepen, inflation refuses to budge or the economy heads toward a recession. Furthermore, as central banks elsewhere make negative rates the norm, the Fed will face mounting pressure to do the same.

The Fed Can Make a Stand

On the bright side, the U.S. economy remains the strongest and the most vibrant of developed markets. And rates in the U.S. are notably higher than rates in Europe and Japan, giving the Fed more room to maneuver.

We believe the Fed should take advantage of its unique position among its fellow central bankers. Specifically, it should seriously weigh its desire to support near-term economic prospects versus the detrimental long-term consequences of negative yields. Perhaps it’s not such a bad idea to let economic cycles and capitalism run their natural course, instead of artificially boosting them. We believe the Fed can and should make a stand against negative rates and avoid succumbing to their intensifying pressure.

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Charles Tan
Senior Vice President
Co-Chief Investment Officer
Global Fixed Income
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