First Denmark, Sweden and Switzerland, then the European Central Bank, and just this year Japan have all introduced negative interest rates as a policy tool designed to 1)depreciate the home currency, 2)encourage lending, 3)stimulate inflation and 4)goose the economy. So far the results have not exactly been stellar. In fact there is a growing body of opinion that negative interest rates have had unintended consequences and may actually be working against the very objectives that central banks wanted.
The theory supporting negative interest rates is that if investors have to pay to invest, then they will invest elsewhere. If US investors owned Japanese bonds at negative interest rates, one presumes that they would sell those bonds and buy bonds in, say, the US, where rates are still positive. As US investors take money out of yen denominated investments, one would expect the yen to decline in value relative to other currencies.
But there are always 2 sides to a coin. What if Japanese bondholders sold out of Japanese bonds to buy US bonds? And then what if they hedged the currency (short the dollar vs yen)? That hedge would work against the Japanese currency going down, blocking the intention of the central bank.
When interest rates are negative, borrowers are, in effect, paid to borrow. Consequently, borrowing should increase, theoretically driving growth in the economy.
From the borrower’s perspective, negative rates sound like a dream come true! But what if banks can’t find depositors who want to pay to have them hold their deposits? (Indeed, the sales of house safes have significantly increased in Japan)? Given that deposits fund lending, could negative rates lower the supply of credit and in some cases even raise the price of credit? In fact, business investment is down in countries that have negative rates. In addition banks may not want to charge their customers to place deposits with them and so profit margins at banks may decline in a not-so-virtuous cycle.
Confused yet? So are the markets! Throw an interesting scenario /theory at any experienced investment professional and usually you will hear that this scenario reminds the pro of some prior event, suggesting a similar resolution. But there is literally no one alive who has seen what is currently going on. Thus the confusion.
How did we get here? It started with quantitative easing. The US central bank bought assets in an attempt to lower interest rates across the board. The lack of yield in the marketplace forced investors to look for higher yielding riskier assets, such as stocks and real estate. The idea was that the resulting higher asset values would make people feel wealthier and that they would then spend money to prime the economy. While this was dreamed up by incredibly smart people, we have to remind ourselves that it is truly an experimental policy. And it hasn’t produced the growth that was expected.
Almost everyone (we are still looking for the outliers!) thought that negative rates in Japan and Europe would result in a weaker yen and Euro. But alas since the beginning of the year the yen has surged by nearly 10% vs. the dollar while the Euro has climbed by nearly 5% vs. the dollar, with the result that most multi-strategy bond and hedge fund managers underperformed their benchmarks.
In the meantime, economic growth remains on the low side and investors are still starved for yield and return as the appreciation of risky assets has slowed. Is it possible that we need higher, not lower (or negative) interest rates?