trending Market Intelligence /marketintelligence/en/news-insights/trending/75FAtlzzqGGNxQHl5jthLg2 content esgSubNav
In This List

World-beating US economy could yet follow Europe into 'Japanification'

Podcast

Next in Tech | Episode 50: InfoSec spending up, again…

Blog

Broadcast deal market recap 2021

Blog

Europe: 5 key OTT trends to watch in 202

Podcast

Next in Tech | Episode 49: Carbon reduction in cloud


World-beating US economy could yet follow Europe into 'Japanification'

As President Donald Trump looks admiringly at Germany’s negative interest rates, policy makers on the other side of the Atlantic are staring enviously in the other direction, while looking nervously over their shoulders in the direction of Japan.

Three times over the past month, Trump has said that the U.S. should cut rates to zero or below so that the U.S. could get "paid to borrow" and refinance its current debt load at a lower rate. What he might not realize is that rather than being a sign of strength, as he has suggested, negative rates are actually an indication that a country is sliding into a toxic brew of low yields, deflation and growth known as Japanification.

While there are advantages of ultralow or negative rates in terms of cheaper borrowing, the danger is that a central bank at zero no longer has any ammunition to stimulate growth when it slows and risks crashing the economy if it tries to raise interest rates. The Bank of Japan's main policy rate has not been above 0.5% since 1995.

In fact, Federal Reserve Chair Jerome Powell has spoken about the need to keep U.S. inflation close to its 2% target lest interest rates fall to a level that would "give the central bank even less firepower to react and we see that road is hard to get off of," he told the House Financial Services Committee earlier this summer.

Far from normal

Powell is wary of the Fed slipping into a negative rates trap even though the U.S. economy currently looks considerably more normal than its developed-market peers. The Fed's benchmark interest rate is at 2.125%, compared with zero at the European Central Bank, which lowered its deposit rate to negative 0.5% on Sept. 12. The BOJ's policy rate is at negative 0.1%, while the Bank of England's main rate is at 0.75%.

The U.S. economy is also growing faster than most of its peers, at a 2% annualized rate in the second quarter after a 2.9% expansion in 2018. The eurozone, by contrast, grew at 1.8% last year and by 0.2% quarter over quarter in the three months through June as Germany contracted by 0.1%. Core consumer price inflation in the U.S. was 1.6% in July versus 0.9% in the euro area and 0.6% in Japan.

Still, the U.S. economy is far from normal. Fed rates peaked at 2.375% in December 2018 before being lowered in August this year. That compares with pre-recession peaks of 5.25% in 2007 and 6.5% in 2000. Consumer prices, as measured by core PCE, the Fed's favorite inflation gauge, has only been at or above the central bank's 2% target for 14 of the past 130 months.

Banks vs. negative rates

The yield curve on U.S. Treasurys has also flattened considerably and at times this year inverted, with the 10-year yield falling below that of the two-year note. However, 10-year Treasury yields have risen by 32 basis points this month and were at 1.83% at about 7.30 a.m. ET on Sept. 16.

The Fed has just begun a cycle of interest-rate cuts of indeterminate length that could take the Fed toward zero relatively quickly. Former Fed Chair Alan Greenspan told CNBC on Sept. 4 that "it's only a matter of time before negative rates come to the U.S."

Banks, which tend to dislike negative yields and flat yield curves because they squeeze their margins, are bracing themselves for the eventuality.

PNC Financial Services Group Inc. has "done a lot of work" to enable lending and deposit systems to operate at negative rates, Chairman, President and CEO William Demchak said at Barclays' recent Global Financial Services Conference. "It's a massive problem," he said.

Regions Financial Corp. and JPMorgan Chase & Co. also said they are planning for negative rates, but JPMorgan CEO Jamie Dimon said he does not think they will arrive in the U.S.

Account fees

Potential mitigation includes cutting costs or charging account fees, but it would be "very hard" to impose negative deposit yields on customers, he said.

The damage done by negative rates can be seen starkly in Denmark, where banks have been dealing with them since 2012. Lenders in the Nordic country, whose central bank lowered its key rate to negative 0.75% on Sept. 12, saw profits slump 20% in the first half, according to industry body Finans Danmark.

Danish 10-year yields were at negative 0.46% on Sept. 16. Other countries with negative 10-year yields include Japan, Germany, France, Netherlands and Switzerland, with a whopping negative 0.77%.

Overall, there are $15 trillion of negative yielding government bonds in the world, one quarter of the outstanding amount, according to Deutsche Bank, which calculates that number has tripled since October 2018.

SNL Image

It all started in Japan, where the central bank began quantitative easing in 1997-1998 in the form of hoovering up commercial paper, and worked its policy rate down to 0.1% by 2001. Prolonged low inflation and rising government liabilities saw the central bank begin to buy up Japanese government bonds, and suppress the cost of debt.

The widespread cheap financing has enabled high debt, low growth companies to struggle on, leaving Japan stuck with "zombie" companies that only survive because of the availability of cheap refinancing, said Romain Boscher, global CIO, equities, at Fidelity International.

The eurozone is rapidly following Japan down the same road.

"The ECB were slow to react to the 2008 crisis and are still suffering from the consequences," Adrian Lowcock, head of personal investing at financial adviser Willis Owen, said after the central bank's latest interest-rate cut.

"Having never been in a position to raise interest rates when the going was good the central bank has been left with few options when the outlook has deteriorated, and there is diminishing benefit from further interest rate cuts and QE," he said. "The Japanification of Europe is complete."

Many economists see the likelihood that the U.S. joins Japan and the eurozone in the negative rates trap as unlikely.

"A long period of no inflation and interest rates stuck at zero ... is a risk but a very low-probability risk," said Ken Matheny, executive director for macroeconomic advisers at IHS Markit.

"But it's a risk policymakers have to keep in mind because the consequences are dramatic. How do you stimulate an economy? Once you get to zero what more can you do to rates? Forward guidance only gets you so far."

Some of those who do see negative rates coming to the U.S., including Alan Greenspan, cite similar demographic forces to those that have helped push Japan down that road, namely an ageing population.

The two most important secular drivers of negative interest rates are demographics and technology, Joachim Fels, managing director and global economic adviser for PIMCO, one of the world's biggest money managers with about $1.75 trillion of assets under management, wrote in August. "It is no longer absurd to think that the nominal yield on U.S. Treasury securities could go negative."

Running out of children

In 2018, 10 of the 28 European Union member states saw their population decline, according to Eurostat. A 1.1 million increase in the overall EU 28 population to 513.5 million was due to net immigration of 1.5 million. Countries such as Italy, Greece, Hungary, Poland and Portugal saw a decline in population, even as net migration was positive.

In the U.S., the situation is currently less severe, but seniors will outnumber under-18s by 2035 as baby boomers retire, according to a 2018 U.S. Census Bureau report.

The good news is that the demographics in the U.S. are not constant and the millennials are larger, but spread out over a larger period than the boomers, Ryan Sweet, director of real-time economics for Moody's Analytics, said in an interview.

"It was clear the U.S. economy was going to age because of the boomers, so the policy response now would be like trying to steer the Titanic the second they realized there was an iceberg," Sweet said.

"Too little, too late."

SNL Image