Are negative interest rates taking developed economies into an upside-down world, or are they simply the latest manifestation of the new normal? S&P Global brought together econ
"What's fascinating is that we used to have this concept of a zero bound," said S&P Global Ratings chief economist Paul Sheard, as well as other fundamental economic ideas such as the time value of money—the basic notion that lending money over time comes at increasing cost to the borrower. At some point, these sacrosanct concepts bit the dust. Negative interest rates (NIR) weren't on the radar of the U.S. Federal Reserve even during the financial crisis. "At some point, the penny dropped," and central bankers began to see negative interest rates as more of the same, instead of something completely different. And rightly so, because it's their job to size the aggregate amount of money in the banking system. Indeed, NIR are working, in that they're pushing down the whole yield curve. And while it's a tax on the banking system, the time value of money and the zero bound are still holding, at least on the liability side of banks' balance sheets—that is for deposits. "Central bankers can only do two things, tighten and loosen, and negative interest rates are an additional tool to ease," Mr. Sheard said.
Three Distinct Types Of Negative Interest Rates
The term "negative interest rates" comprises three phenomena:
- Negative interest rates that central banks are applying on commercial banks' overnight deposits at central banks;
- Negative interest rates in the bond markets; and
- Companies issuing debt with negative coupons.
That said, the three are related. For example, central banks' negative interest rate policies are pushing down interest rates in some government bond markets to below zero, which has resulted in the issuance of some debt at negative interest rates.
That said, there are variations on central banks' negative interest rate policies (NIRP), which make them that much more difficult to understand. The European Central Bank (ECB) cut its deposit rate to below zero, Sweden its repo rate, and Denmark its main policy rate, for instance. The Bank of Japan introduced a negative anchor rate on banks' marginal excess reserves in late January after more than 15 years of ultra-low interest rates and quantitative easing. "I'm not a fan of negative interest rate policies," said Mr. Sheard, "mainly because they are counterintuitive and confusing to the public." They go against a central bank's job is to manage inflation expectations by communicating a clear and transparent policy. "But if you create a scheme that is so complicated that the likes of us around this table struggle to get our heads around it, you've lost that transparency," he said. Don't such contorted instruments indicate that an economy ought to consider something more straightforward, like fiscal policy?
What's more, the various NIRPs are aimed at different end-games. In Sweden, Switzerland, and Denmark, it's all about defending the currency. In the EU, the ECB has a number of stated and unstated goals that it aims to address through a panoply of programs—such as quantitative easing and TLTROs, an NIR-like program that essentially gives cash to banks for a more aggressive loan balance sheet--all while keeping an eye on the direction of Fed policy, said Jean-Michel Six, chief economist for Europe, the Middle East, and Africa at S&P Global Ratings. The ECB's stated goal is to lift inflation to near 2%, but it would also like to reduce financial fragmentation in the eurozone, foster bank lending, and weaken the euro's foreign exchange rate with the U.S dollar.
One of the most immediate effects of all NIRPs was a drop in benchmark 10-year government bond yields to less than zero. The value of the assets affected is enormous, said Jason Giordano, director of fixed-income product management at S&P Dow Jones Indices. Globally at the start of 2016, a total of $3.6 trillion of assets were negative yielding, which skyrocketed to $8 trillion after the Bank of Japan carried out its rate cut in January, and peaked at $13.5 trillion on July 5 and is currently $11.2 trillion, comprising mostly Danish, Swedish, Swiss, and Japanese bonds. In terms of GDP, negative-yielding sovereign debt represents 17% of global GDP. By mid-July, the entire Japanese yield curve was negative, Switzerland's was negative out to 20 years, and Sweden's out to 15 years. In sum, 25 countries all had some part of their yield structure below zero.
The Yield Curve As A Sign Of Inflation Expectations
In the era of negative interest rates, Mr. Giordano asked, can the market still depend on yield curves to predict inflation in a country? Or have they been manipulated beyond usefulness? Mr. Sheard responded that the distortion the market perceives may actually represent the transmission of monetary policy by central bankers, who aim to flatten the yield curve.
In monitoring global credit conditions, S&P Global Ratings is seeing that NIRP is starting to lower unemployment rates, said chief economist Robert Palombi, who heads the company's credit condition committees, and in that way are incrementally contributing to recovery. The committee's concern is that since negative interest rates are a tax on savings, it could create an incentive to investors to pull their money out of the financial system and put it into bank vaults. However, Mr. Palombi believes that's not happening yet, because there is actually a cost to storing money, which the IMF calculates to be about 1%-2%. Plus, we're not seeing indications that negative interest rates are producing stress in the economy.
So far, signs of a boost to the economy from Japan's NIRP have been difficult to discern, said Ryoji Yoshizawa, director, financial institutions, at S&P Global Ratings, noting that the country has operated under very low interest rates for more than 15 years. Indeed, after negative interest rates were adopted, Japanese share prices dropped in value. Meanwhile, the low and now negative rates are creating uncertainty and having unintended consequences, with the household and corporate sectors carrying significant surplus savings. Mr. Yoshizawa projects that core operating profits at major Japanese banks are likely to fall 8% because of direct and indirect NIRP effects, and 15% for the country's regional banks. Meanwhile, bank lending is not showing any substantial increase.
Warping The Yield Curve
While they aren't a cure-all, NIR do generally seem to be a good way to weaken exchange rates, said David Blitzer, Ph.D., managing director, index management, at S&P Dow Jones Indices and chairman of the Index Committee. Beyond that, however, they introduce a distortion into financial markets, for example, in warping the yield curve as a risk indicator. "We're seeing much more interest in speculative-grade bonds and junk bonds, anything with high risk compared to the whole spectrum." Central banks are encouraging banks to take on risks that they normally wouldn't want to take on.
While central banks are pushing banks to lend more, regulation is delivering a different message: don't take risk, noted Mr. Six. This comes at a time when some banking systems, for example, Italy's, are still saddled with high levels of nonperforming loans. It also explains why actual trends in bank lending remain fairly weak.
Risk is on the rise in the reallocation of capital for nonfinancial corporates as well, as a result of low rates, said Diane Vazza, managing director of fixed-income research at S&P Global Ratings, on the back of "soaring issuance across all asset classes that's defying all expectations." For example, 10-year credit spreads on U.S. investment-grade corporates (versus those on the 10-year U.S. Treasury bond) are off their 2009 peak of 336 basis points to 190 basis points currently, while speculative-grade spreads are down to 558 basis points from levels eight years ago of 1,029 basis points. Corporates have also been able to extend their debt maturity profiles; for example Europe has seen the most growth in 10-year and greater maturities. In Asia-Pacific, 40% of companies are issuing 10-year bonds, double the share of just a few years ago. What's worrying from a credit perspective is the rise in the 'B' rated issuer. "We saw that movie before, prior to the last recession," Ms. Vazza said.
Central banks seem to be ignoring consequences of such risk-taking, which were at the heart of the last financial crisis, said Franklin Allen, Professor of Finance and Economics and Executive Director at the Brevan Howard Centre for Financial Analysis at Imperial College London. Rising prices for assets like housing will inevitably burst, bringing the banking sector down, with spillover onto the real economy. And bringing the banking sector back to health takes a long time. "Today, we've never seen such low interest rates, and we've never seen such high asset prices," Mr. Franklin said. Japan is an example of the negative long-term effects of ultra-low interest rates: it went from having a vibrant financial sector to one that is moribund, with not much lending to the real economy and a corporate sector that has lost its status as one of the most competitive in the world. The answer doesn't lie in a fiscal surge either that builds bridges to nowhere, but perhaps in a regular long-term program of infrastructure investment.
Banks Are On The Defensive
It might be too early to say whether NIRP is hurting European and U.K. banks. In crunching the data, Firdaus Ibrahim, senior equity analyst at S&P Global Markets Intelligence, was surprised to find that their net interest margin (NIM) actually rose 1 basis point from 2012 to 2014, and 4 basis points in 2015. Excluding U.K. banks, NIM fell in the two years to 2014 but still rose in 2015. He supposes banks are repricing deposits and loans to cope with the margin pressure of lower interest rates.
"The lesson from the data is that it takes time for asset and liability repricing to feed through to bank reported financials," said Richard Barnes, senior director in the banking team at S&P Global Ratings, "and banks have put into place balance sheet hedges to protect their margins." The effect of NIR is already showing up in the lower market capitalizations for European banks, whose shareholders doubt they can make decent returns. Although banks cannot pass on negative rates to their retail customers, and are under considerable political pressure to lower borrowing costs, they are passing on negative rates to corporate and institutional clients, and are charging higher fees across the board. One silver lining is that credit losses are running low because with NIRP, borrowers have more financial capacity to pay back their loans.
What will happen if NIRPs persist in the next one to two years? Cristiano Zazarra, head of global risk services relationship management at S&P Global Market Intelligence, said he sees further fee compression, and investors moving into higher-yielding but risker speculative-grade and emerging-market debt, and shifting to passively managed funds with typically lower fees. Hedge funds are likely to rethink their expensive fee structures, Mr. Zazarra said.
Negative interest rates are also throwing a wrench into the valuation of market risk, which banks use to assess capital requirements. That's because just a few years ago, the most common valuation models were calibrated with the assumption that interest rates would be zero or positive. This has implications for stress test scenarios and hedging interest rates, said Hans Crockett, product manager and developer at S&P Global Market Intelligence. "Some systems simply refused negative interest rates as inputs," he said. Systems can be adjusted to a point, though mathematically log normal volatility assumptions just don't compute at negative values. Plus, a lot of valuation models use as an input some kind of mean reversion assumption, that is, things go back to normal over a certain period of time. Under negative interest rates, what is back to normal? What is the period of time?
Money Market Funds: The Canaries In The Coal Mine
The first financial sector to feel the effects of negative interest rates were money market funds, which invest in very short-term and short-term investments. "Money market funds are the canaries in the coal mine," said Andrew Paranthoiene, director at S&P Global Ratings. To pass on negative rates to investors, the industry adopted the idea of share cancellation to maintain their price at 1 (euro or other currency) per share for stable net asset value funds. While the industry has seen outflows and consolidation, investors—among them multinationals—see value in these funds as diversified pools of highly liquid and high-credit-quality instruments. They're seeking safety and liquidity first, and then yield.
Negative interest rates are the main threat to European insurers today, especially for the life business, said Lotfi Elbarhdadi, analytical lead in the insurance practice at S&P Global Ratings. That's because interest rate assumptions are the backbone of pricing. Yet, companies are adapting by modifying product features, for example, eliminating or reducing guarantees on new business. "They're becoming more of a fee-based rather than a spread-based business," and becoming more like asset managers than insurers. Mr. Elbarhdadi doesn't see insurers taking on significantly more risk, because of regulatory constraints, but he does see them extending asset maturities on their investments in the search for yield. One positive outcome of negative interest rates is that conditions for issuing debt are favorable, and insurance companies are releveraging.
A World Unprepared For Low Rates
In structured finance, partly because they are without legal precedent, NIR have created a potential for dispute risk over negatively calculated coupons, some of which do exist among the issuance we rate, said Darrell Wheeler, managing director, structured finance research, at S&P Global Ratings. Most of that paper was originally issued between 2005 and 2008 when nobody anticipated negative interest rates. In the past 18 months, however, we're not seeing issuance of floating-rate notes without floors. What's more, most of our criteria is sized to high interest rate stresses. "I think the world is well prepared for a high rate environment. I'm not sure it's well-prepared for the stresses of a low rate environment."
The conundrum for commodities is that the fall in prices was one reason behind NIRP, and that it may actually increase deflationary pressures in the sector in the medium term, according to Yulia Woodruff, director of client strategy and energy solutions at Platts. NIRP is lowering the costs of carry and encouraging the buildup of inventories, and reducing the costs of production by cannibalizing investments in higher-cost projects. "Most commodity markets are supply-long, and investments aren't likely to increase until the markets rebalance and the price outlook is positive," Ms. Woodruff said.
In what was otherwise a cloudy assessment of negative interest rates, Niels Lynggard Hansen, director and head of economics at Denmark National Bank, spoke about the country's successful use of the policy. He explained that Denmark's use of NIR is to solely defend the currency—a different rational than in other countries—and is in the context of a fixed exchange-rate policy that's been in place for more than 30 years. Although housing prices have increased, and strongly in Copenhagen, higher disposable income and changing demographics explain much of the rise. Pretax profit at the country's seven-largest banks was strong in 2015, though admittedly net interest income has decreased and banks are increasing fees to compensate. Should the ECB have introduced a tiered scheme of negative interest rates, like Denmark's, thus better shielding the banking system?
Will It All End In Tears?
Negative interest rates might not be as abnormal as they sound, if the natural rate of interest has fallen, in which case the zero bound is likely to be broken. However, when the next downturn hits, how will policy respond? If S&P Global Ratings' forecasts prove to be correct, that won't happen. In theory, the Fed would be the first one out of the gate with higher interest rates, and other central banks would follow step by step, exiting from their negative interest rate policies, said Mr. Sheard. If that takes too long, a downturn would leave central banks with a tough policy challenge. It's difficult to imagine that the answer will be to lean on the central banks to do more. Monetary policy is stretched, and close to the limits of what it can do. Will it all end in tears?
Besides being difficult to understand, NIRPs are creating an excuse for central bankers to avoid talking about how fiscal policy can help. Central banks might be able to put the discussion back on the table by reintroducing the idea of perpetual bonds, which pay interest but don't pay back principal. It comes back to the question: how do we get out of the slow-growth quagmire? Are central banks relying too much on the notion that negative interest rates can stimulate the economy? As one panelist put it, "We've got to get back to the world where the financial services industry focuses on identifying good investments so economies can grow."