Industry Voice: Negative rates: More harm than good?

PIMCO believes that negative rates policy does not have much further room to run. In this article, we discuss the implications for investors.

clock
Industry Voice: Negative rates: More harm than good?

NEGATIVE RATES: A TWO-SIDED COIN

Why are negative nominal interest rates so troubling? Economic theory favors real rates, which have already been negative in most developed countries for some time. In theory, lowering the nominal policy rate into negative territory should produce many of the same expansionary effects as cutting the policy rate in a positive rate environment: to make individuals and companies save less and spend and invest more. Lower real rates should also lead to a depreciating currency, which improves a country's external competitiveness, and supports asset prices, boosting the wealth of the private sector.

In practice, though, negative interest rates come with three key drawbacks:

  1. They impair the banking system. As the policy rate turns more negative, banks start earning less return on their assets, while the interest they pay on deposits generally stays above zero - due to relatively high competition for deposits, legal challenges, political resistance and the potential for cash withdrawals. As profits decline, banks may issue fewer loans to businesses and households, or raise the interest rate they charge for those loans. Lower bank equity prices risk exacerbating these effects.¹
  2. They create significant challenges for other parts of the financial system. This includes the pension and insurance sectors, which offer nominal return and minimum income guarantees in the future, but that are hard to deliver when interest rates are negative, as they don't generate enough yield.
  3. Negative nominal rates may lead to more, not less, savings. Economists refer to this concept as "money illusion," as what should matter - at least if people were completely rational - are not nominal but rather real, or inflation-adjusted, variables. While "money illusion" may hold for rate cuts in a positive rate environment too, the effects are likely magnified under the zero line.

WHAT'S THE EVIDENCE SO FAR?

We studied the effect of negative rates in five different countries, drawing some conclusions on their effect on financial markets, bank deposits, lending rates and volumes, and macro variables, such as growth and inflation. Our universe includes: Denmark (which first brought the policy rate into negative territory in July 2012), Eurozone (June 2014), Switzerland (December 2014), Sweden (February 2015) and Japan (January 2016). We found that:

  • The policy has been successful in easing financial market conditions so far. Negative policy rates (figure 1) have led to a fall in both short-term and long-term market rates, with 2-year and 10-year government bond yields on average declining roughly as much as policy rates (figure 2). However, the policy looks to have had mixed impact on countries' currencies: while the euro and Swedish krona underperformed, the yen and the Swiss franc appreciated (figure 3). The policy also had a positive impact on risk assets, with stock prices on average rising, although this result is skewed by a significant rise in Denmark. Importantly, bank equity prices have suffered in the negative rate environment, challenging the sustainability of any improvements in financial conditions.
  • The impact on bank lending conditions appears to have been positive. On balance, banks have lowered household and corporate deposit rates, though by less than the policy rate, while lowering lending rates roughly as much as the policy rate. On average, financial institutions have increased the pace of loan creation (figure 4), especially in the Eurozone, albeit from a low starting level.
  • The macro impact seems to have been positive, but modest. While the policy has been associated with stronger growth (figure 5), the dispersion of outcomes has been high. On the other hand, the policy appears to have been unsuccessful in lifting inflation (figure 6) and inflation expectations. In this regard, we note the European Central Bank's (ECB) analysis that negative rate policy has had the least impact on growth and inflation relative to the other easing measures it has implemented recently.

 

Important Information

This message contains confidential information and is intended only for the individual named. If you are not the named addressee, you should not disseminate, distribute, alter or copy this e-mail. Please notify the sender immediately by e-mail if you have received this e-mail by mistake and delete this e-mail from your system. E-mail transmissions cannot be guaranteed to be secure or without error as information could be intercepted, corrupted, lost, destroyed, arrive late or incomplete, or contain viruses. The sender, therefore, does not accept liability for any errors or omissions in the contents of this message which arise during or as a result of e-mail transmission. If verification is required, please request a hard-copy version. This message is provided for information purposes and should not be construed as a solicitation or offer to buy or sell any securities or related financial instruments in any jurisdiction. Please note to the extent that we collect any personal data we will use that personal data in accordance with our Privacy Policy  https://europe.pimco.com/en-eu/general/legal-pages/privacy-policy#howweuseyourdata. PIMCO Europe Ltd is registered in England and Wales Company No. 2604517 and has its registered office at: 11 Baker Street, London, W1U 3AH.

More on Investment

Industry Voice: 'Net Zero by 2050 won't happen without Asia'

Industry Voice: 'Net Zero by 2050 won't happen without Asia'

Investment Week and ThomasLloyd Group
clock 18 May 2022 • 5 min read
Event Voice: Your Questions Answered by Baillie Gifford at the Sustainable Investment Funds to Watch

Event Voice: Your Questions Answered by Baillie Gifford at the Sustainable Investment Funds to Watch

Alasdair McHugh, Investment Specialist, Global Stewardship, Baillie Gifford
clock 17 May 2022 • 5 min read
Josh Mayne, Lowes Financial Management

Investors see positive returns on structured products

Q1 2022 maturity results

Josh Mayne
clock 11 May 2022 • 3 min read
Trustpilot