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Below zero: what negative interest rates mean for investors

26 April 2016 in Investing 101

Below zero: what negative interest rates mean for investors
With the Federal Reserve’s FOMC meeting starting today, we thought we’d cast some light on all the fuss swirling around negative interest rates. Negative rate policies are now in effect in a few countries something that markets tend to view as an act of last resort. So, what gives?

Key Takeaways

  • A negative interest rate policy serves to combat deflation, currency appreciation and foreign hot money inflows.
  • Deflation is a vicious cycle that requires a change in consumer confidence.
  • By the time we enter a negative interest rate policy, it may be too late for our equity investments. Conventionally, investors interpret an increase in negative interest rate policies around the world as a signal to get more defensive. 

When you borrow money, you expect to owe a bit more than what you borrowed based on your loan’s interest rate. You also expect to earn a little bit of money on cash deposits you make at your bank based on your account’s APR. But what if both of those situations were the reverse – that is, you owe less than you borrowed and you lost a little on your deposits? That’s the gist of negative interest rates.

Click on image to enlarge.

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Negative interest rates mean borrowers get to pay back less money than they took out. Depositors wind up paying banks to hold their cash as well. Source: The Wall Street Journal.

Space invaders versus negative interest rates
Imagine space invaders land on Earth like a terrifying scene out of “Independence Day.” Aliens start to blast down doors and take everybody’s personal belongings with force. When they’re done pilfering, practically all you have left is your life and the shirt on your back. The only way to keep your valuables and stash cash safe is to deposit everything you have at the bank, which is protected by an anti-alien force field designed to keep the invaders out.

Everywhere, frantic citizens scurry to banks in order to protect their money. The sudden surge in demand spurs banks to start charging depositors to store their money. As a depositor, you hastily decide to accept the charges because you’d rather pay some interest than have your precious remaining dollars confiscated by aliens.

When an economy is in turmoil, deflation tends to rear its ugly head because everybody wants to hoard money. The result is often a collapse in aggregate demand because everyone starts curbing their purchases and consumer spending slows, which can lead to prices falling even further. With no demand for loans, banks begin to decrease lending and the economy slows. Eventually, if things get bad enough, you might start wondering whether an alien invasion might be better than getting stuck in a deflation death spiral with no job!

What happens in a negative interest rate environment?Aggressive fiscal policy expansion (e.g. government infrastructure spending) or an equally aggressive monetary policy (e.g. a negative interest rate policy) are tools that governments use to battle the vicious cycle of deflation.

If a central bank decides to target its policy interest rate below zero, several things can happen. As borrowing costs (interest rates) drop, more businesses and consumers take up loans driving up spending and investments. As a result, consumer confidence and employment gradually increase, increasing the demand for money. Then, deflation starts to turn into inflation as goods and services get more expensive.

Deflation is one of the trickiest situations to solve because consumers think, “why should I shop now if deflation is expected to continue? I can save money if I wait and make my purchases in the future because further deflation should continue to lower prices.” This self-fulfilling prophecy can only be broken by improving consumer confidence, which happens when the employment picture improves. Seeing your neighbor buy a brand new luxury vehicle doesn’t hurt either.

Why go negative?
Central banks try to balance a healthy level of inflation with a robust rate of employment as much as possible. For example, the Federal Reserve targets a 2 percent annual inflation rate and a Non-Accelerating Inflation Rate of Unemployment (NAIRU) between 4 to 5 percent.[1] In other words, the Fed strives for a happy equilibrium where an unemployment rate between 4 to 5 percent results in a constant 2 percent annual inflation rate.

If inflation starts to head above the long-term inflation target, the Fed may raise the Fed Funds rate to make borrowing costs more expensive and slow down the economy. After all, nobody wants to live in a world where the cost of everything outpaces the cost of income growth. Conversely, when inflation is below the long-term inflation target, the Fed may cut its rate to stimulate borrowing and spending. A negative interest rate policy is an extreme monetary policy of last resort.

Besides combatting deflation, central banks can dial in a negative interest rate policy for two other key reasons.

  • Put a lid on aggressive currency appreciation. Countries that rely heavily on exports may see a drop in demand for their goods if their currency gets too strong. During the 1970s, the Swiss government ran a negative interest rate regime to counter its currency appreciation as foreign investors sought stability from inflation in other parts of the world.[2] Today, with turmoil in China and disruption in oil producing nations like Brazil, foreign money is buying U.S. dollar denominated assets, causing an appreciation in our currency. Raising interest rates further is likely to attract even more international money flow and make our export industry even more uncompetitive. It’s no wonder that expectations for future rate hikes have been tempered.
  • Pour cold water over hot money inflows from foreign investors. Let’s say a small country finds a significant new natural resource that could double its GDP over the next several years. Without proper capital controls, foreign money could flood its economy buying up everything, including real estate and businesses, to take advantage of the impending boom. Unfortunately, wealthy foreign investors can crowd out local residents who are squeezed out of this prosperity. A central bank can help save its people from foreign interests with their hot money by enacting a negative interest rate policy and more capital controls.

How do negative interest rates affect investors?
Investors should always be aware of any peculiarities in interest rate policies around the world because stock markets are intricately linked. Right now, Denmark, Sweden and Japan have turned on negative interest rate policies to help spur economic growth and stem deflation.

Sweden and Denmark’s interest rates are currently in negative territory. Sweden’s rates have steadily fallen since 2012, according to The Wall Street Journal.[3]

If more countries start adopting a negative interest rate policy, this could be a sign that global growth and corporate profits are slowing. Declining profits may cause valuation multiples for major corporations to shrink and bring down stock market indices all over the world.

Click on image to enlarge.

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Japan has issued the largest amount of negative interest rate debt at $5.6 trillion followed by Germany and France. Source: The Wall Street Journal.

With increasing fears of global deflation, there may be a short-term increase in demand for higher dividend yielding securities. Eventually, companies may cut down their dividend payouts to conserve cash and get more in line with the interest rate market.

Unprofitable companies or those with very tenuous business models may get hurt more than blue-chip companies that have tremendous cash flow. Fixed income could get bid up, in line with stock investors demanding higher yielding dividend companies. Eventually, fixed income securities rise to a point where their yields fall in line with various lower rates all along the yield curve.

Although borrowing money for free may be nice, most investors don’t really want a negative interest rate regime. Such an extreme policy is put in place to try and fix a macro problem. Large-scale fixes impact large-scale issues. This is one reason advisors say it’s more important than ever to invest in the companies that can raise prices, increase their margins, take market share and grow their earnings faster than the industry average and certainly faster than the overall market.

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Investing in securities involves risks, you should be aware of prior to making an investment decision, including the possible loss of principal. An investment in individual stocks, or a collection of stocks focused on a particular theme or idea, such as a motif, may be subject to increased risk of price fluctuation over more diversified holdings due to adverse developments which can affect a particular industry or sector. Investments in ETFs can include those with a narrow or targeted investment strategy and can be subject to similar sector risks than more broadly diversified investments. Motif makes no representation regarding the suitability of a particular investment or investment strategy. You are responsible for all investment decisions you make including understanding the risks involved with your investment strategy.

Investing in securities involves risks, you should be aware of prior to making an investment decision, including the possible loss of principal. An investment in individual stocks, or a collection of stocks focused on a particular theme or idea, such as a motif, may be subject to increased risk of price fluctuation over more diversified holdings due to adverse developments which can affect a particular industry or sector. Investments in ETFs can include those with a narrow or targeted investment strategy and can be subject to similar sector risks than more broadly diversified investments. Motif makes no representation regarding the suitability of a particular investment or investment strategy. You are responsible for all investment decisions you make including understanding the risks involved with your investment strategy.

 

[1] Board of Governors of the Federal Reserve System, “Why does the Federal Reserve aim for 2 percent inflation over time?” Board of Governors of the Federal Reserve System, 2016.

[2] Schneeweiss, Zoe, Jan Schwalbe, “Swiss impose negative rate echoing 1970s amid Russia crisis,” Bloomberg, December 17, 2014.

[3] Duxbury, Charles, David Gauthier-Villars, “Negative rates around the world: how one Danish couple gets paid interest on their mortgage,” The Wall Street Journal, April 14, 2016.

  1. Abdulaziz
    28 Apr at 5:36 am

    It was very informative as also eye opening, keep up the good work, it helps in making investment decision. Thanks

    Reply
  2. Syam
    28 Apr at 9:09 am

    I love Motif Investing and the appreciate Motif team on good work.

    Having said that, this article is a nice propaganda piece for Central Bankers failed monitory policies all over the world. ZIRP and now NIRP are symptoms of Central Bankers running out of ideas to prop up economy, The core problem is fiat currency system. Inflation itself is theft of Producers wealth, in stealth manner.
    Personally, if negative interest rate becomes reality, I would stop investing and focus on paying down debt. Any excess cash will be used towards income producing assets or real money (gold and silver).

    Please stick to innovating and disrupting personal investing space. Main steam media does more than enough in spreading lies about finance.

    Reply
  3. Rudi
    28 Apr at 1:08 pm

    Great perspective. If it plays out, the USA should be investing in infrastructure soon.

    Can someone build a Motif “USA Infrastructure” that would provide positive returns if there is an effort from the USA to improve its infrastructure: roads, airports, public transport, etc?

    Reply

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