Negative interest rates have become more prevalent in the past couple of years in central banks’ bid to shore up growth and stoke inflation. But at what point do they become counterproductive?

Incredible though it seems, there are five central banks that currently have a negative interest-rate policy. Turning conventional practice on its head, commercial banks in Switzerland, Japan, Sweden, Denmark and the eurozone now have to pay to deposit funds at their central bank. The theory goes that as banks are penalised for holding on to excess reserves, they are likely to lend more to businesses and individuals, so stimulating growth and inflation in the economy – things that have largely been lacking in the aftermath of the financial crisis.

Yet following the financial crisis, commercial banks are increasingly risk averse and being encouraged by regulators to increase capital reserves as a buffer for periods of turmoil. Earlier this year, financial stocks across Europe witnessed a sell-off as it became evident that by not passing negative rates onto customers (charging them for having deposits), banks were likely to see margins squeezed.

Conventional theory can be thrown out the window in a negative interest-rate world. A prime example was seen in the Swiss Canton of Zug where penalties for late payment of taxes were removed – as holding excess deposits was actually costing the government! And anecdotal stories abound with regard to the increase in sales of safety deposit boxes in Japan, which demonstrate that there is a level at which individuals will simply withdraw cash and keep it at home rather than pay for the safety of a bank. This does not apply solely to individuals, with German insurer Munich Re announcing that it was to start storing at least $11m in its vaults.

Can Negative Rates


While such instances have been rare, it does suggest that there is a limit to how far negative rates can go without being counterproductive. If banks fear that they are likely to see large withdrawals, this might lead to reduced appetite for lending, thereby reducing the availability of credit and possibly the money supply – and ultimately hampering economic growth. This serves to highlight the dilemma for central bankers as they seek to stimulate growth and inflation in such an uncertain time. Some inflation is beneficial in that it helps nominal growth and cuts the real value of debt for governments.

The ramifications of the extraordinary measures taken to stimulate global economies are evident in the fixed-interest market. As the chart below illustrates, shorter-dated government securities in Europe and Japan are guaranteeing a loss for investors (offering a negative yield) if bought at current levels and held until maturity.


Source: Bloomberg Finance LP, Deutsche Bank Global Markets Research.  As at April 2016.  For illustrative purposes only and should not be viewed as a recommendation to buy or sell.

The rally in government bonds has in part been fuelled by the quantitative easing programmes instituted by major developed-economy central banks which bought government debt from banks (driving up prices and pushing down yields), again in an attempt to boost lending.

If banks fear that they are likely to see large withdrawals, this might lead to reduced appetite for lending, thereby reducing the availability of credit

One might expect that if a bond was going to guarantee a loss there would be no buyers. But many financial institutions and pension funds are forced buyers because of their need to meet regulatory obligations. In uncertain times, investors have rushed to the ‘safety’ of government bonds, and any continued easing of monetary policy could see prices rise (yields fall) further.

Another reason for buying bonds on negative yields is to protect against deflation. We do not subscribe to the view that inflation is dead – indeed, we think the market may be underestimating inflationary pressures – and as such remain cautious on some parts of the bond market for long-term investors. The ratings agency Fitch has estimated that negative yields in the fixed interest market is costing investors some $24bn in foregone income, and this is impacting pension funds that are struggling to plug widening deficits.

In a recent report the International Monetary Fund has stated that the effects of negative interest rates have been broadly positive, but that there are limits to its effectiveness. It is interesting to note that the global consultancy firm McKinsey has revised down its future returns expectations from both bonds and equities for the next 20 years. It estimates that US equities have returned 8% annually for the past 30 years, while US bonds have returned around 5% on a real (inflation-adjusted) basis. Going forward, its projected returns have been revised down to 4-5% from equities and 0-1% from bonds. This highlights the challenge that investors face in a low return world.

We continue to adopt a diversified approach in portfolios, looking for companies that can grow in difficult market conditions and have the ability to provide solid cash flows. Within fixed interest, we remain wary of what we see as expensive valuation levels, although we also appreciate the fact that they have a low level of correlation with equities.


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