With respect to deflation, by June 2014, the European Central Bank cut rates into negative territory. While its currency, the Euro, had been weakening the whole time, it was more focused on thwarting deflation fears. Deflation is difficult to defeat so extraordinary measures are being taken. For decades, Japan has struggled with low levels of inflation, and finally, with the help of enormous central bank intervention, Japan actually saw more normal levels of inflation in 2014, but inflation has since waned. The Bank of Japan does not want deflationary sentiment to come back, so at its January policy meeting, it joined the negative interest rate club.
The fight against currency appreciation and deflation explains negative short term rates, but what explains why longer term bonds have negative yields?
I think the answer goes back to deflation and currency devaluation. Switzerland, Sweden and Japan have all had more than a few years of deflation since the financial crisis, while inflation in Germany hovers around 0%. Investors buying bonds at negative rates are not buying them for income like a typical investor does. They are investing for risk management purposes. For example, investors seeking to avoid devaluation of their local currency would rather be invested in a stronger currency even if it means taking a small loss of interest. Banks, for example, are forced to own government bonds to meet regulatory requirements. If you are a European bank required to own sovereign debt, you certainly wouldn’t want to own too much Italian or Greek debt, so the only alternatives are to balance that risk with the low-to-negative yielding debt in the strong countries.
I understand these reasons for negative rates, but there are lots of reasons for concern. While counterintuitive, the longer we have negative rates on longer maturity debt, the more I worry about deflationary sentiment taking root. Using negative rates for too long could spur destabilizing currency wars. We just witnessed the devastation in markets in August when China had to devalue its currency. China could not support its peg to the dollar given how strong the dollar was becoming as the Federal Reserve was preparing to raise U.S. rates. What happens to the supply of credit and liquidity in the system when we face the prospect of having to pay to be invested in a money market fund? How confident can we be in our banks knowing their profits are being squeezed if they cannot pass on negative rates to their depositors? If banks do pass through negative rates, they risk losing depositors who are their main funding source, and then banks will be even less able to lend. What are the societal consequences of effectively taxing savers with negative rates and then effectively or even actually paying people to borrow money?
So where does it stop?
There is a theoretical boundary for how low negative interest rates can go. With the exception of very large depositors, banks are not passing the negative interest rates they are being charged onto their customers, but at some point they may have to in order to stay profitable. Savers and investors may be willing to put up with slightly negative rates because there is a cost to doing something else with their money, like the cost of buying a safe to put it in, but there is a limit. Money used for liquidity and for commerce purposes can also be interest-rate agnostic, but at some level they too will find a cheaper way. Some European central banks believe the lower bound for policy rates is around -0.75%.
When the Chair of the Federal Reserve, Janet Yellen, was asked about the possibility of negative rates in the U.S. during her semiannual monetary policy report to Congress in February, she stated they have not found any legal reason they couldn’t use it as a tool for monetary policy, but thus far, they were not considering it. We can always cling to the idea that, “it will never happen here,” but Yellen’s answer felt to me like it opened the door a little, and markets reacted violently to the idea. Those two days of her testimony marked the lows in the stock market and the widest credit spreads in the bond market for 2016 thus far. Markets have recovered since mid-February, and thankfully, during her press conference after the March Federal Reserve meeting, Yellen repeated unequivocally that negative interest rates were not being considered. Hopefully, all this unconventional monetary policy stops where it started, here, in the U.S.
In the meantime, bond investors need to be nimble by focusing on total return strategies, not just income, and being diversified to keep risk in check.
Wendy W. Stojadinovic is director of fixed-income strategy at Cleary Gull.