Any remaining hopes that 2016 would be the year of rising interest rates have been dashed. Faced with sluggish global growth and stubbornly low rates of inflation, several major central banks have embraced ultra-low and even negative interest rate policies (NIRP) over the past few years in an attempt to stimulate their flagging economies.
The success of these policies has been mixed, however, and financial markets have greeted more recent moves into negative territory, in Europe and in Japan, with a lukewarm reception. But while the effectiveness of NIRP remains to be seen, investors have no choice but to find ways to navigate the ultra-low and negative interest rate environments given that these policies are likely to remain on the table until inflation and growth are back on track.
Propping up growth
Some central banks have turned to negative rates following a period of ultra-low interest rates when they feel they have no other tools left to stimulate the economy, devalue the currency and prop up inflation. When the European Central Bank (ECB) first resorted to unconventional negative interest rate policies, it in effect started charging banks for holding their reserves with the intention of forcing them to loosen their purse strings and lend more. This, it hoped, would encourage people to spend more, thus boosting GDP growth and pushing up inflation.
Another feature of negative interest rates is the expectation that they would weaken a domestic currency. Faced with negative rates, investors would look for better returns abroad, leading to a depreciation of the currency and a boost to economic growth. Negative interest rates are also a tailwind for exporters and help to create import-led inflation. Following the lead of the ECB, the Bank of Japan (BoJ), perhaps encouraged by the European results, adopted NIRP in January 2016.
The problem with negative rate policies is that it is difficult to say conclusively that they work. ECB President Mario Draghi has widely credited NIRP with improving lending activity in the eurozone, supporting economic growth and warding off deflation. But the jury is still out. NIRP remains an experimental policy, and there are concerns about potential unintended consequences.
On the positive, the policy has lowered the cost of financing for many corporates. Consider that close to two-thirds of eurozone bonds now offer negative yields, as do all Japanese bonds of less than a 15-year maturity. This has encouraged investors into the corporate bond market, bringing down the cost of borrowing. But it is difficult to know whether NIRP alone is keeping the economy afloat given that the aggressive expansion of the central bank’s balance sheet, through its bond-buying programme, has also played a key role.
But it has produced mixed results in other areas. In terms of currencies, after the ECB introduced negative deposit rates in June 2014, the euro initially plunged more than 20 percent against the U.S. dollar. In Japan, negative rate policy had the opposite of the desired effect. When the BoJ slashed interest rates to -0.1 percent in January this year, the yen unexpectedly strengthened.
NIRP has also had limited success in stoking inflation. It is possible the deflationary spiral in Europe was averted thanks to it, but there is evidence that inflation expectations in Europe remain stubbornly low. Over in Japan, it is too early to draw a conclusion, but the strong yen would have hindered the return of inflation.
NIRP and ultra-low interest rate policies can also have unintended consequences. For one, negative interest rates are bad for savers and pension funds who receive meagre returns on their savings and bond investments. The low-yield environment means savers will have to save for longer and spend less, and the topic of pension deficits will once again rear its head.
Beyond this, a potential side effect on the banking system could also sabotage the policies. Commercial banks usually react to interest rate cuts by lowering the rate they charge borrowers, but in order to maintain profitability, banks have to lower the rate they offer on deposits. As interest rates get close to zero and below, this could push banks to charge for deposits. They are often reluctant to do this because it could scare away depositors, thus squeezing margins and eroding the capital position. As they fret over their profitability and capital position, banks are unlikely to extend credit.
Curbed market enthusiasm
Overall, it seems financial markets are less enthusiastic towards ultra-low and NIRP policies. And while risk appetite initially increased when the ECB cut interest rates in April to -0.4 percent from -0.1 percent and announced its corporate sector purchase programme, the unexpected market reaction in Japan probably means the BoJ has a higher hurdle rate before it can go further, according to Eric Lascelles, Chief Economist at RBC Global Asset Management.
If NIRP’s mixed results continue, alternative policies may well emerge. One option is so-called helicopter money, whereby central banks directly fund government spending, such as infrastructure programmes, rather than buy bonds. Lascelles believes that the likelihood of helicopter money is low. It would erode the barrier between central banks and governments, compromise central bank independence and credibility, create a risk of inflation rising significantly and could be viewed negatively by financial markets. Moreover, several central bankers, such as Mark Carney at the Bank of England (BoE), have already pronounced their opposition to it.
One development is that central banks are starting to coordinate better and more central bank and fiscal policy. Following the Brexit vote, the UK government abandoned its strict fiscal target. Newly appointed Chancellor Phillip Hammond has alluded to resetting the fiscal policy if deemed necessary, and an infrastructure programme could be announced in the Autumn Statement.
More to come in Europe?
We don’t expect the UK or U.S. to tread down the road of negative interest rate policies, though their interest rates could stay ultra-low for quite some time.
In the UK, BoE Governor Carney has recently lowered interest rates to 0.25 percent and announced a substantial quantitative easing programme. He expects UK rates to be cut further to “close to, but a little above zero,” thereby reiterating his stance against adopting negative interest rate policy. In the U.S., we believe the next rate hike is likely to be next year, at the earliest. Even so, interest rates should remain low, in our view, and gradually reach 0.75 percent in a year’s time.
As for the ECB, it is gauging the impact of the measures announced in April 2016. But this holding pattern is unlikely to linger and the ECB will act one way or the other. If the economic backdrop improves significantly, driving inflation expectations higher, the ECB could refrain from further easing. On the other hand, continued stagnation would likely compel the bank to move interest rates deeper into negative territory.
How NIRP affects investment decisions
In this ultra-low and negative interest rate environment, our preference is for U.S. equities. At present the U.S. economy appears to be on solid ground with no recession in sight; the manufacturing and services sectors are growing, unemployment is low and wages are rising. Within this we would focus on quality companies that can withstand and perform during a time of low interest rates and low economic growth, with a focus on those that have good cash flow and growing dividends.
In fixed income, we believe investors should focus on corporate bonds given that government bonds currently offer low or negative yields. Again, we prefer North American investment-grade corporate bonds, although it is important to be selective given that bond prices have risen as a result of high demand from investors. We also believe there is a case to be made for holding European corporate bonds. Low inflation expectations, fair valuations and the introduction of the ECB’s corporate bond-buying programme should all help to support the European bond market and provide reassurance for investors.