August 30, 2019
It is becoming ever more apparent that negative interest rates are here to stay. A central bank innovation that was assumed to be a flitting adjustment in order to breathe life back into the post-financial crisis economy is now a mainstay. With global growth cooling to tepid at best, central banks, who, less than 12 months ago were contemplating rate hikes – are again brandishing the scissors, ready to cut rates once more. Enter the new reality of ‘lower for longer’. Given that interest rates touch every area of investing, this has various implications, for capital market participants, banks, corporations, governments, savers, investors and consumers.
Let’s begin with the why.
Central banks try to maintain a Goldilocks economy: Not too hot, but not too cold
The primary objective of the major central banks is to maintain price stability, in order to help foster stable economic growth. Here in Europe, the European Central Bank has the mandate of achieving ‘a year-on-year increase in the inflation for the euro area of below, but close to 2%.’ In doing so, they aim to stop the economy from over-heating (resulting in run-away inflation), but keep it safely out of deflation’s grasp.
Avoiding a quicksand of deflation
Deflation is an economy’s worst nightmare because once you are in it, it is difficult to get back out. Deflation expectations act as a black hole for economic activity, where everything is postpone to the day after tomorrow. In the eurozone, it is not the moment to press the panic button about deflation, but inflation rates have been stubbornly low, despite the ECB’s efforts to coax them upwards. In the midst of a cyclical slowdown, Mario Draghi and his team, are expected to announce a grand easing package at their meeting on September 12th. This could include a fresh asset purchase program, extended forward guidance… and a rate cut.
The ECB’s deposit facility rate
The interest rate is a central bank’s key policy tool, which in theory, can be dialed up and down to influence economic performance.
It is widely expected that the ECB will cut its deposit rate from -0.4% to -0.5% in September — with some predicting it could go even further after that.
The deposit facility rate is the interest banks receive for depositing money with the central bank overnight. Since June 2014, this rate has been negative, meaning that banks must pay in order to deposit cash with the ECB (which they are obliged to do). On an annualized basis, it’s currently estimated that eurozone banks are paying around €7.6 billion to the ECB on surplus deposits.
By charging this negative rate, the ECB hopes that eventually this will spur consumers and corporations into spending. Healthy economies need confident consumers with loose purse strings. The ECB wants people to put this money to work. To invest in value-adding projects, to take risk, to invest in firms allowing them to expand and innovate, to encourage consumers to buy that install conservatory now rather than later. It wants firms to go ahead and build that new factory, to get the cogs turning. And, in theory, the halcyon days will be here.
But obviously, for the economy to function, a healthy banking system is a prerequisite. Until now, banks have shouldered the costs of this without passing the fees onto clients. In retrospect, perhaps banks should have passed these costs onto customers, because indeed, by absorbing all of the costs onto their own balance sheets, banks may have partly diluted the ECB’s efforts to encourage spending. But now, with no end in sight with regard to lower rates, and with traditional income streams drying up (from carry and spreads), several banks, are now obliged to levy a safeguarding fee on large cash deposits, in order for their business model to remain sustainable.
New milestones in financial repression
Banks have traditionally served as cash transformation machines. They collect money from savers, and lend it out over longer time horizons. The differential between the rate on the loan and the interest they pay to savers, historically delivered profits.
The fixing by the ECB (and other CB’s around the world) of negative rates was supposed to be temporary. Everyone was expecting rates to align to the natural equilibrium rate of saving and lending. The unorthodoxy of having a negative central rate has now been biting for more than 5 years.
On top of structural factors which are resulting in light supply and too much demand (demography, emerging countries transitions, the service economy transformation, regulatory pressures,..) new paradoxical chapters are beginning to flourish. It is not only that some countries face negative central rates, others are now grappling with a downward sloping yield curve (short term interest rates being higher than long term interest rates), while in some, the entire curve is in negative territory (i.e. every tenor of government bond offers a negative yield to maturity).
According to Bloomberg calculations we are now operating in a world where $17 trillion of bonds deliver a negative yield to maturity. And this phenomenon is not exclusive to bonds issued by governments (perceived as being secured), it has extended to the world of corporate debt issued by private companies. The only reassurance is that Rest assured that, negative coupon bonds have not been invented yet. Negative yielding debt, or bonds which will be worth less, not more, if held to maturity, are becoming mainstream. Sub-zero bonds look like they are here to stay, with implications for all economic agents, especially savers who will take a direct hit from this ‘new normal’ in which lenders pay for the privilege of supplying money! In essence, another important law of financial logic is now broken: if you lend money for longer, you should see a higher return, this is not valid anymore. The time value of money just disappeared. To sum-up, what was supposed to be a temporary heresy, looks set to stay for longer. What was supposed to be limited to short-term rates has now extended to most maturities. What was supposed to be a premium paid for the privilege of holding perceived safe-haven government debt is now spreading to the corporate world.
This all leads to a distressing context for savers. It calls to mind the song Lullaby by The Cure – “Spiderman is eating me for dinner”. But procrastination, and staying frozen like a deer caught in headlights, is not the proper attitude to adopt. Some may consider withdrawing all of their cash and storing it under the metaphorical mattress. The problem with that is that we essentially live in a cashless society. Items over a certain price tag have to be paid for with plastic.
The writing is on the wall and the financial landscape for the foreseeable future is going to be characterized by negative rates. Whether we like it or not, it is like that. But for investors, there are viable alternatives to avoid the slow-burning effect of negative rates on cash deposits. As central banks venture further into an unorthodox experiment of negative interest rates, we must find ways to navigate this new terrain – as the adage goes, you can’t stop the waves, but you can learn how to surf.
Author: Group Investment Office