Negative interest rates

Normally a potential lender can choose not to lend and just sit on the funds. That is equivalent to getting a nominal interest rate of zero. At the minute however, several countries have introduced negative nominal interest rates whereby lending/depositing money with central banks will incur an interest charge – so you need to pay to park your money i.e. get an interest rate of less than zero.

In the Eurozone, Denmark, Sweden, Switzerland and Japan, central banks have decided to impose a negative rate on commercial banks’ excess funds held on deposit with them. In the case of Sweden, the central bank has gone below zero on the rate it lends money to the banks, its main policy tool.

The aim in the Eurozone is to lower rates, incite banks to lend, consumers to spend, economic growth stimulated and to raise inflation – which is below zero and adrift of the European Central Bank’s target of close to 2%. In Sweden, it is about raising inflation whilst in Denmark and Switzerland the immediate objective has been to prevent the currency rising too much. The currency is rising because of too low inflation which is making goods in the country more competitive to foreign entities, these entities are purchasing more of the country’s product and thereby purchasing more of the currency thus raising the demand and value for the currency. The idea of lower and negative interest rates is to discourage foreign and domestic investors from depositing within banks/buying the local currency and pushing the value of the currency up. Investment is also below its pre-crisis levels in the great majority of these rich countries so lowering rates should assist growth.

There has been a decline in 10 year bond yields over the years globally as central banks have been continuously reducing rates (resulting in rising bond prices and lower yields). A decline in long-run interest rates has consequences for monetary policy. The equilibrium rate is the interest rate that is consistent with stable inflation and output at its potential level. Setting short-term interest rates above this rate will bring down activity and inflation. Setting them below this rate of course has the opposite effect of bringing up activity and inflation.

Since the global financial crisis, inflation has been low worldwide and growth subdued – perhaps indicating that interest rates are may still be too high and that we need to carry on dropping rates to increase inflation and activity.

The implications of this however;

  • If one bank goes negative, others could follow. Currently the big banks are already very well funded and don’t need any more deposits so if they were overwhelmed by a flood of customers switching accounts, they would have to detract customers from giving them extra deposits that they have to pay interest on by also sending interest rates into the negative zone.
  • Rather than paying a central bank negative deposit rate, banks could buy government bonds which might be less costly, even if there is a negative return. It may also be preferable to lend money to another bank or a government rather than pay to keep it at the central bank.
  • Some types of risk averse investment funds essentially have to buy government debt, so there is a certain amount of what has been called passive investment going on despite the poor returns. These investors may need to take more risks and invest in areas elsewhere where there is growth.
  • Low interest rates are unwelcome news to savers, making it seem better to spend now. Those who choose to continue saving have an alternative to not paying these negative rates and earn a (higher) 0% interest rate by keeping the money in hard cash under the mattress, but this can be a problem in terms of risk of theft for large companies with big cash reserves. This is also a problem because taking money out of the system affects liquidity. The above applies to larger businesses, however to Small companies and individuals, they do not pay negative rates – they simply get no interest, leaving them at the mercy of inflation but at least preserving the cash in their pockets.
  • Large companies in Sweden are typically willing to pay negative rates to keep cash with their banks, as the other available places to store money – the bond markets, money market funds, and short-term loans to other businesses – will likely charge them even more.
  • Negative yielding bonds can be a good investment for potential bondholders if inflation falls below the yield on the bond. Investors buy these bonds in the expectation that they will make a positive return after inflation drops.

 

Bank of Japan and the Yen

Japan surprised markets in January when it set a minus—0.1% rate on some deposits that banks place at the central bank, effective from mid-February. The move was designed to encourage banks to lend more, spurring higher spending and inflation. Yet that has not been the case so far.

Lower interest rates normally lead a country’s currency to depreciate, helping its exporters.

However instead of depreciating, the yen has risen against all major currencies due to now being thought of as a haven currency amid uncertain global markets, the slowdown in neighbouring China and by the dollar’s recent weakness after the Federal Reserve pared back expectations of U.S. interest-rate increases.

Demand is also coming from an unusual source: foreign investors, who in the past have largely stayed out of the low-yield market but have recently jumped in because of rising returns on Japanese-bond trades thanks to the cheaply funded yen.

Traders also have pushed up the yen believing Japan’s central bank can’t do much more to ease policy.

At the beginning of August, the government introduced a stimulus package of 28 trillion Yen in order to try to devalue the strong currency. This will be beneficial to Japanese stocks who get most of their revenue from overseas. This boost in exports will revive the economy.

10 year government bond yields rose at bonds were sold off as investors sought riskier assets such as stocks.