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22 May: the gift of negative interest rates

6½ mins
Rebecca Cretney, 
May 2020
22 May: the gift of negative interest rates

Last week, the chairman of the Federal Reserve (Fed), Jay Powell, said: “The committee’s view on negative rates has not changed. This is not something we’re looking at.” The statement came despite pressure from the market, and President Donald Trump, who tweeted: “As long as other countries are receiving the benefits of Negative Rates, the USA should also accept the ‘GIFT’. Big numbers!” 

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A low rate policy makes sense. When you want an economy to grow, you make it very cheap for companies to borrow so they can invest in their businesses. Many countries also need very low rates so they don’t fall over given the ballooning amount of debt around the world, as they do “whatever it takes” to protect their economies.

Trump is pushing Powell because negative yields would not only reduce the cost of borrowing and stimulate spending, they would put downward pressure on the US dollar. A cheaper dollar makes imports more expensive, so people would be more inclined to purchase US manufactured goods, both in the US (as foreign imports become more expensive) and abroad, as US products become cheaper everywhere. The stock market also benefits, as it would be cheaper for foreign investors to buy US stocks. This is why Trump is calling the change a “gift”.

There is clearly another side to the coin of negative rates. Reduced savings rates mean groups, such as pensioners, have to up their appetite for risk to search for yield. There could also be a possible spike in inflation, while corporates would need to maintain adequate cash reserves due to their increased costs, as imported components become more expensive.

Trump is correct in stating that other countries are already benefiting from lower yields: the German 10-year Bund (its government bond) is yielding around -0.54%, the French 10-year bond 0.03%, the UK 10-year gilt is marginally higher at 0.23%, and the US 10-year is the highest on this list with a yield of 0.64%. These yields aren’t going to change much anytime soon. Central banks are determined to keep rates at record lows, particularly for shorter duration bonds, through quantitative easing.

There is a serious possibility of yields going even lower, particularly if we see a second wave of COVID-19 given there’s no vaccine on the horizon. It’s just too early to ‘call the bottom’, and say that economic growth and investment prices are likely to start to trend upwards.

But can the market force the hand of the Fed? And what about other central banks, such as the UK and Australia, who have also made similar statements about the road to negative rates?

If only the answer were a simple yes or no. While it is less likely to happen for 10-year bonds, shorter maturities could easily trade below zero. It has happened in the UK, and could in the US given the Fed has lost control of the yield curve in the past.

Although Powell is dismissing the market signals now, the market could prove to be correct. Much depends on how the story continues to unfold, particularly with regard to economic growth, inflation and the value of the US dollar.

 

A case study in negative rates

To look at whether the US, UK and Australian central banks will move into negative territory for 10-year paper, it’s useful to look back at when banks in Europe switched to negative rates in 2014 and 2015.

The Financial Crisis was in the rear-view mirror, but growth wasn’t picking up as expected. A big drop in oil prices meant that disinflation was on the cards, which could end in deflation. Memories of Japan were still fresh in policy makers’ minds – an economy that went from hero to zero and then beyond. Due to deflation, between 1991 and 2001, Japan suffered what many call “a lost decade”. If it is cheaper to invest tomorrow, you will wait until tomorrow. And as tomorrow never comes, a vicious cycle develops.

The Eurozone needed to encourage lending to get the economy moving, but at the time credit had been contracting by 5% per annum. So banks were pushed to lend more as the primary route for company financing. How do you encourage banks to lend? You make it painful for them to hoard money in the central bank’s vaults through negative interest rates. The plan worked. After a couple of years of getting used to the then ‘new normal’, credit finally started growing and did so, until very recently, at around 4% per year. It made sense from a political point of view given the huge levels of national debt in Italy, Greece and Spain.

However, Europe’s panacea isn’t necessarily right for everyone. Negative rates may be a good policy for the European Central Bank (ECB) to follow, but the picture in the US is different. The US has a much bigger corporate bond market, so corporate funding isn’t as much of an issue. So, the Fed focuses on talking about the cons, while keeping a keen eye on inflation, which could be the natural bi-product of negative rates.

 

What does this mean for other assets?

Equities tend to rally for a number of reasons. First, because investors are forced into the markets in search of return. Second, the cost of borrowing is reduced for corporates, so their profits increase and they have more funds available to reinvest into their businesses.  

Property benefits, as more people are attracted to buy property given the lower cost of borrowing.

Commodity prices tend to increase, because the cost of financing stockpiles, and preventing supply issues, is lower than when interest rates are high. 

 

What can clients expect if they require an income?

Bonds (corporate and government) are one of the most common ways of generating a higher level of income than is available through cash. After bonds, you look to property and high yielding equity.

Corporate debt prices have fared significantly better than we expected at the outset of the crisis. In other words, yields have remained low. One of the main reasons for this was the extension of the Fed’s powers to buy corporate debt, where previously this support was only available to the Bank of England and the ECB. The possibility of negative rates adds to this.

We manage portfolios which specifically target returns in the form of income. Although for clients who require an income, yields have fallen – the drop is modest from around 3.9% in 2019 to around 3.5% now.  The drop in income yield is primarily because of changes we have made to the income portfolios, reducing higher yielding credit, in particular in emerging markets, which we cut entirely. Instead we favour lower yielding, but safer, investment grade and government bonds. The reason we can maintain such comparatively high yields is because of our diversified income flows and, in particular, our alternative investments.

However, bond yields could go lower if Trump has his way and the US rates go negative. But how far could negative rates go?  The floor for negative yields is around -1%. That is because there is a price to pay to hold cash e.g. the cost of renting a safety security box. Any lower than that would see wholesale depositors withdraw all their accounts.

 

Back to Powell. We have seen before that he is willing to do a U-turn if it’s in the US’s best interest. In 2019, the market priced in at least two rate cuts, and some even expected a third. Powell’s initial response was not to pay heed, but he ended up cutting rates relatively quickly. We may therefore see the Fed becoming equally fleet of foot, particularly if the US dollar continues to strengthen in value. If the currency appreciates just 5-10%, it would put the EUR/USD pair at parity, see deflation kick in, and so prompt the push for negative rates globally.

Clients of Nedbank Private Wealth can get in touch with their private bankers or relationship managers directly to understand how their portfolios are responding to market events, or call +44 (0)1624 645000.

If you would like to find out more about how we can help you manage your investments, please also contact us on the same number as above to understand how we might manage your money.

It’s important to note that investments can go down, as well as up, to the extent that your original sum might be impacted. Past performance is no guide to future returns. Any investment mentioned here may not be suitable and you should always seek advice before investing.

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Rebecca Cretney

Rebecca Cretney

Investment Counsellor

Rebecca joined Nedbank Private Wealth in May 2004 having moved to the Isle of Man from Barcelona to pursue a course in Business Studies with the Isle of Man Business School. Rebecca was appointed to the role of investment counsellor in March 2019 to focus exclusively on the company’s discretionary investment management services. She works closely with our teams of private bankers to provide support in advising our clients with integrity, and to give additional technical investment expertise where more complex portfolio requirements exist. Rebecca is a Chartered Fellow of the Chartered Institute for Securities & Investment and a Chartered Wealth Manager.

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