InvestorQ : When the interest rates are negative in the market (like in Japan and Sweden), what are the larger implications for investors?
rhea Babu made post

When the interest rates are negative in the market (like in Japan and Sweden), what are the larger implications for investors?

2 years ago

Would you be happy to put money in your bank if the bank tells you that you have to pay the bank to keep money with them? You will obviously be shocked but that is exactly what negative interest rates are all about. Let us look at six such implications of negative interest rates on investors and their portfolios. Let us also look at what exactly will get impacted by negative interest rates in the economy.

· Firstly, what will negative interest rates mean for central bank monetary policy? Central banks like ECB and BOJ are currently in a corner as they do not have room to cut rates any further to prop growth. The theory that cutting rates will spur growth has not been evident in the last 10 years of loose monetary policy globally. Central banks have used negative rates more to suppress their currencies versus the dollar to spur exports. Even that has not worked as global trade has shrunk in the last 3 years.

· Negative interest rates makes fiscal deficit palatable, but that can be misleading. Since rates are negative, a high ratio of Debt/GDP look palatable, which can be misleading when rates start to rise. Negative rates may spur households and governments to go on a spending spree due to availability of easy money.

· What do negative rates mean for treasurers of large companies? Treasurers have a unique dilemma of matching their long term liabilities with matching investment yields. Negative rates throw the entire concept of maturity matching of assets and liabilities off target, especially for banks. Treasurers may become victims of the myth of substantially cheaper debt versus equity and in the process they may ignore the solvency risk to the company.

· Very interestingly, what do negative rates mean for equity investments? Technically, falling rates are positive for equities as they reduce the cost of capital. That is not necessarily the case with negative interest rates. That means, banking stocks are the most vulnerable as they will be hit by compressing yields and also will have to pay central banks to park.

· Negative rates create an easy money scenario and hence valuations tend to be high to due to excess liquidity in the system. This creates asset bubbles in equities market as we are seeing global market cap touching $1 trillion. Negative rates are a sign of the central bank’s weak outlook for economic growth.

· There are also implications of negative interest rates on the bond markets and the currency markets too. Here is how. Negative rates typically create a flattening of the yield curve as yields at the long end of the curve fall sharper than the short end. This is normally a led indicator of a slowdown in the economy overall and that is the trend that we are seeing in the US bond markets today. Let us move to currencies. What do negative rates mean for global currencies? Negative rates create currency crowding. For most of last year we saw investors crowding to the US$. Normally a crowded trade creates volatility in the currency. Negative rates are a proxy for devaluation and this has the potential to degenerate into a full-fledged currency war. Emerging market currencies are the most vulnerable. We saw how China devalued the Yuan indirectly in August 2015 resulting in a domino effect across emerging market currencies. In fact, it is now being feared that with the likely impact the trade war, this could also spread to global markets in the current context.

Negative interest rates go against the basic tenets of time value of money and hence are not economically sustainable. Global markets have not been in the grip of negative rates for such a long time in recent memory. To that extent, it is a novel experience for global markets and they will take time to adjust to the new order. With oil prices continuing to remain low, inflation unwilling to pick up and growth elusive, it looks like negative rates are here to stay. Unless, of course, the US Fed decides to embark on aggressive rate hikes which looks unlikely, at least for now!