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Wall Street to Your Street
What's So Negative About Negative Interest Rates?
April 29, 2016 | Mark Simenstad, CFA, Head of Fixed Income Mutual Funds
The term "negative interest rates" has become a growing theme in the global economy, but what exactly are negative rates? And why are skeptics beginning to worry about the economic ineffectiveness and potential repercussions of this policy in Europe and Japan? Negative interest rates refer to a monetary policy in which government bonds actually pay out less than the original investment amount.
It would be like putting $1,000 in a bank savings account only to see your balance beginning to drop below $1,000 rather than increase in the months and years ahead. The same principle applies to government bonds issued with negative interest rates – the dollar amount the investor pays for a bond exceeds the amount received at maturity.
Worldwide, about $7 trillion in government bonds now trade at less than 0%.1 The leading issuers of negative rate bonds are Germany, Japan and Switzerland. While the U.S. is not issuing bonds with negative interest rates, the U.S. government bond market has fallen into the range of negative real interest rates this year, as market rates paid on 10-year U.S. Treasuries have been below 2% since Jan. 27. That is below the 2.2% rate of inflation in the U.S. through the first quarter of 2016.2
The negative real rate is defined as a bond or debt instrument yield below the current rate of inflation. If you have money in a money market account, for instance, you are experiencing negative real interest, because most money market accounts pay 0.01% or less, which is well below the rate of inflation.
Why go negative?
Central banks in Europe and Japan have been using extreme monetary policies to try to stimulate economic growth and a little more inflation. Currently, many countries are bordering on deflation, which is not healthy for the growth of an economy.
By lowering interest rates to near or below zero, these governments hope to encourage increased borrowing by businesses and more spending by consumers.
In the process, the policy is hurting savers, who are earning little or no interest on their savings, and it's hurting the banks, which are unable to make money on deposits because they receive a negative yield on the government bonds they buy.
How is it working?
The jury is still out on whether or not this extreme policy will work. But so far, in our view, there has been little evidence that it has done anything to boost economic growth.
Not only is it hurting the banking industry, it has also had the effect of slowing down consumer spending. With negative interest rates, consumers now believe they need to stash even more cash to compensate for the negative rates. They are saving more now instead of spending.
With a slow economy and little consumer activity, manufacturers are reluctant to spend more money to expand capacity or increase production. Even though a large supply of money is available at historically low rates, companies aren't borrowing and the economies in Europe and Asia remain stagnant.
Our biggest concern now is that if the economy slows even further, there is little wiggle room left for the central banks to stem the tide. Their primary stimulus – a large supply of money at very low rates – is already in place to little avail. So what would they do if the economy slows even further?
Although the U.S. has fallen into the "real" negative rates category, it's recent market interest rate of about 1.8% for 10-year Treasuries is still far better than most of the world. As a result, foreign investors have been buying U.S. bonds – a strategy that has worked well.
They receive a higher return than bond yields in their own country and they have benefited from a strong U.S. dollar that has increased in value versus all of the world's other leading currencies over the past two years.
But for U.S. investors, the influx of foreign investors has driven down the effective yield they can earn on U.S. bonds. We believe the best antidote to resolve the negative interest rates quandary would be an uptick in the global economy, leading to increased consumer and business spending.
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1 Source: Bloomberg
2 The core inflation rate is a combination of the core Consumer Price Index, or core CPI, and the core Personal Consumption Expenditures price index, or core PCE price index, as determined by the U.S. Bureau of Labor Statistics.
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