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Negative-Interest-Rate-Policy-Adds-Up-To-Less-than-Zero-for-Investors

Negative Interest Rate Policy Adds Up To Less than Zero for Investors

Key Points
  • Nearly one-third of developed market stocks are from countries where central banks have adopted a negative interest rate policy (NIRP).

  • QE lifted stock prices; NIRP seems to be depressing them.

  • While the main economic risks of NIRP have yet to be realized, increasingly negative interest rates may weigh more heavily on the stock market and pose a threat to the drivers of the global economy.

While central banks’ QE programs helped lift stock prices in recent years, the latest shift by several central banks to a negative interest rate policy (NIRP) seems to be weighing on stocks and may be working against their intentions of promoting economic growth.

NIRP is gaining popularity with 30% of the value of stocks in the MSCI World Index now represented by companies domiciled in NIRP countries. The increasing number of central banks adopting NIRP is weighing on the profit outlook for financial companies that now must pay to hold some of their reserves at the central bank and hurting the performance of the global financial sector. This has left its mark on performance in 2016 since despite the further sharp decline in the price of oil this year; it is the financial sector, not energy, which is leading the MSCI World Index to the downside in 2016.

Stocks usually track underlying global economic growth represented by the global composite purchasing managers index (PMI), as you can see in the chart below. During the Fed’s QE programs, stocks were temporarily lifted above the pace of economic activity. Now, as central banks increasingly adopt NIRP, stock market performance has been depressed below the trend in the global economy.

NIRP adds up to less than zero for investors

 

NIRP adds up to less than zero for investors

Source: Charles Schwab, Bloomberg data as of 2/3/2016.

The NIRP club added another member last week: the Bank of Japan (BOJ). Japan’s pace of economic activity rose in January, measured by the widely watched composite purchasing managers index. However, a rebound in the yen and further declines in oil prices and inflation expectations prompted the Bank of Japan to introduce NIRP last week and join the club of central banks with a policy rate less than zero that includes the Eurozone, Sweden, Switzerland, and Denmark. Japan’s stock market, measured by the Nikkei 225 Index, was down 4% for the week.

Examining the risks

When QE was new, a big risk often cited but never materialized was the potential for soaring inflation as excess reserves could lead to rapid growth in the money supply. NIRP is a relatively new tool for central banks and it is worth exploring the risks of this increasingly popular policy.

A main concern over NIRP is that in order to cover the cost of holding excess reserves at the central bank, banks could have to push up lending rates, which could slow borrowing and the economy. Fortunately, data from the European Central Bank (ECB) shows that this does not appear to be happening in Europe where NIRP was adopted in mid-2014. In fact, lending rates have fallen and banks are lowering lending standards for borrowers for the first time since before the 2008-09 financial crisis, suggesting NIRP may have provided its intended incentive to encourage lending and support economic growth. However, as more countries adopt the policy, competitive currency devaluations may force central banks to push rates even deeper into negative territory. If that were to happen, banks might not be able to boost loan volume enough to cover the added costs and they may be forced to increase rates. So, while slightly negative rates may be manageable, trying to boost the impact by lowering rates further may pose more risk than benefit to the economy.

Europe’s adoption of negative policy rates did not lift lending rates

 

Europes adoption of negative policy rates did not lift lending rates

Source: Charles Schwab, Bloomberg data as of 2/3/2016.

A different risk of negative rates is that savers could pull their money from banks and bonds and stuff it in their mattresses and starve the economy of funding. As a result of Japan’s adoption of NIRP, yields on 2-year, 3-year, and 5-year Japanese government bonds fell into negative territory, while 10-year yields fell to a record low just above zero. Yields across other NIRP countries are also very low with 10-year yields in Germany, Sweden, and Switzerland at or under 0.5%. Nevertheless, there is still solid private sector appetite for these bonds even at these negative yields.

So far, banks have mostly avoided negative rates for depositors so that risk has yet to be tested and bank deposits remain on the rise, according to ECB data. But this test may come soon if increasing NIRP adoption and competitive pressures force policy interest rates even lower in some countries.

European savers prefer banks over mattresses for now

 

European savers prefer banks over mattresses for now

Source: Charles Schwab, Bloomberg data as of 2/3/2016.

Finally, another risk of negative rates relates to the potential for savers to decide to save more and spend less now that the interest rate they are earning on their savings is flat or negative. Again, there is evidence that this risk has not been realized. In fact, with the exception of Switzerland, the growth rate in the volume of retail spending in NIRP countries has picked up following the implementation of negative rates. It seems that flat or negative savings rates have encouraged spending in these countries with historically high saving rates rather than even more saving. But here also, if rates drop significantly from current levels a negative impact on spending may be felt.

New main policy tool

Central banks’ use of QE asset-buying programs has proven effective at helping lift stock market valuations, but they have shown little success at boosting economic activity (as highlighted in the recent commentary Central Banks to the Rescue?). It appears that NIRP is becoming the main policy tool for a number of major central banks as they battle falling inflation, rising currencies, and economic weakness.

Our perspective is that while the main risks of NIRP have not yet been realized, the negative reaction in the stock market poses a threat to the global economy. The effectiveness of slightly negative interest rates is far from assured and increasingly negative interest rates may not just weigh more heavily on the stock market, but on drivers of economic growth as well. While we believe that the global economy will avoid a recession in 2016, central bank moves toward more deeply negative interest rates would elevate the risk of prolonging and deepening the slide in the stock market.

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Important Disclosures

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