OB Report
November 2019
Page 1 - 2  |  Page 3 - 4  | Printable PDF (2.6 MB)

 

What's With Negative Interest Rates?

Murray Leith By Murray Leith CFA, Executive Vice President & Director, Investment Research

article1Jyske Bank, Denmark’s third largest, made history in August by offering the world’s first negative interest rate mortgage. For a 10-year term, Danish homeowners can borrow at -0.5% per year.

With a negative interest rate, borrowers still make monthly payments as usual. However, the sum of the monthly payments over the term of the mortgage equates to less than the principal amount borrowed. For example, a million-dollar mortgage at -0.50% would require 120 monthly payments of $8,125 totaling $975,000 over the 10-year term. The borrower is essentially paid $25,000 to borrow the funds.

How is that possible? How can a bank afford to pay a borrower? How does the economy function properly with negative interest rates? These are good questions, and they boggle the mind!

The mortgage is possible because Jyske Bank is able to borrow from institutional investors at negative rates. The bank is simply passing this good fortune on to its customers – if you can call it good fortune.

At the time Jyske Bank launched its negative interest rate mortgage, more than $17 trillion of the world’s debt was trading with a negative yield to maturity. Most of this is issued by governments in Europe and Japan, although there are some corporate bonds with negative yields as well. Even Greek three-month treasury bills recently traded at a negative yield!

Bonds in Europe and Japan have negative yields because their central banks helped push them there with extremely accommodative monetary policies. Interest rates on short-term bonds have fallen because the administered rates set by the European Central Bank and the Bank of Japan have been reduced to negative territory. Meanwhile, interest rates on long-term bonds have dropped below zero because these institutions continue to execute big bond-buying programs (quantitative easing); bond-buying pushes prices up and yields down. The hope, of course, has been that ultra-low interest rates would stimulate the European and Japanese economies, and yet growth remains sluggish.

Some think it is only a matter of time before we have negative interest rates in North America. While we are not sure if that will occur during the current economic cycle, we are definitely pondering the possibility. What does it mean when interest rates are negative, and why would someone want to buy a bond with a negative yield? We can think of five possible reasons:

  • Fear – Investors accept a small loss on the bond because they believe stocks, real estate and other assets will perform worse.
  • Price Speculation – Investors believe the economic outlook will deteriorate and interest rates will go even more negative, which would push up the price of already negative-yielding debt.
  • Currency Speculation – Investors believe the currency of the bond will appreciate enough to create a gain that will more than offset the loss from the negative interest rate.
  • Purchasing Power Protection – Investors believe the general level of prices will fall and that they will receive a positive “real” return after inflation. A bond with a -1% interest rate would be a good investment if there is annual deflation of 5%. An investor’s purchasing power would increase by 4% per year.
  • Forced Buying – Institutional investors have to accept prices (and yields) as offered because they are mandated to allocate money to the bond market.

None of the foregoing explanations is comforting. Rather, if investors are pricing bonds correctly, the outlook is downright depressing. That was certainly our interpretation until we read Richard Koo’s book titled The Other Half of Macroeconomics and the Fate of Globalization.

Mr. Koo, a respected economist and expert on balance sheet recessions, argues that monetary policy loses its potency after bubbles burst and the private sector (consumers and businesses) has to repair its balance sheets. In his opinion, interest rates are extremely low today due to an absence of private-sector borrowers.

After bubbles burst, the private sector tends to focus on saving – paying down debt and repairing balance sheets. In Japan, the private sector has been a net saver of funds since the country’s twin real estate and stock market bubbles burst in 1990. Similarly, the German private sector has been in saving mode since the bursting of the dot-com bubble in 2000, while most of the private sectors in the rest of the major western economies shifted from borrowing to saving following the 2008/09 Financial Crisis. Interestingly, Canada is a rare exception; our private sector appetite for leverage has continued unabated.

Mr. Koo believes a country’s government needs to borrow and spend when its private sector is saving and repairing its balance sheets. If governments don’t offset private sector savings with borrowing, economies will contract. In a leveraged world, shrinking economies are deadly, as they can lead to a self-feeding deflationary spiral.

Japan has avoided a deflationary disaster and maintained a reasonably healthy economy since its bubbles burst, largely because its government has run large budget deficits. On the other hand, many countries in the European Union are struggling because they are bound by a law that forbids deficits greater than 3% of GDP. That’s not enough when private sector saving is a greater percentage of an economy.

The good news is that there seems to be a growing appreciation by thought leaders that governments have a larger role to play in nursing economies back to a healthier state. Mr. Koo believes governments should take advantage of the large pool of private sector savings and ultra-low interest rates to fund infrastructure and other socially desirable projects that will provide attractive returns. These projects will stimulate economic growth and accelerate the pace of private sector balance sheet repair.

Once balance sheets are mended and the private sector shifts back to being a net borrower, interest rates will likely rise as individuals and corporations once again compete with governments for funds. Indeed, if central bank bond-buying programs aren’t sufficiently reversed by that time and government deficits aren’t simultaneously reduced, interest rates could rise significantly.

It’s impossible to know whether central banks and governments will do what’s needed or whether they will make mistakes. Given the level of social unrest in the world today, and the associated polarization of politics, it is not unreasonable to worry.

The bottom line is it is really hard to predict the future of interest rates. There is a risk of deflation, which could send interest rates even lower, and there are inflationary possibilities, which could cause interest rates to soar.

Because the world has never experienced negative interest rates before, we can’t look to history for guidance. Instead, we take seriously the negative economic outlook implied by the bond market. Consequently, we continue to advise a high-quality approach to investing. We want to own the securities of the best companies and the strongest institutions and governments in this uncertain time. Now is not the time to speculate on higher-risk investments.


Please read our Odlum Brown Limited Disclaimer and Disclosure - It is important!

Odlum Brown Limited is an independent, full-service investment firm focused on providing professional investment advice and objective research. We respect your right to be informed of relationships with the issuers or strategies referred to in this report which might reasonably be expected to indicate potential conflicts of interest with respect to the securities or any investment strategies discussed or recommended in this report. We do not act as a market maker in any securities and do not provide investment banking or advisory services to, or hold positions in, the issuers covered by our research. Analysts and their associates may, from time to time, hold securities of issuers discussed or recommended in this report because they personally have the conviction to follow their own research, but we have implemented internal policies that impose restrictions on when and how an Analyst may buy or sell securities they cover and any such interest will be disclosed in our report in accordance with regulatory policy. Our Analysts receive no direct compensation based on revenue from investment banking services. We describe our research policies in greater detail, including a description of our rating system and how we disseminate our research here.

This report has been prepared by Odlum Brown Limited and is intended only for persons resident and located in all the provinces and territories of Canada, where Odlum Brown Limited's services and products may lawfully be offered for sale, and therein only to clients of Odlum Brown Limited. This report is not intended for distribution to, or use by, any person or entity in any jurisdiction or country including the United States, where such distribution or use would be contrary to law or regulation or which would subject Odlum Brown Limited to any registration requirement within such jurisdiction or country. As no regard has been made as to the specific investment objectives, financial situation, and other particular circumstances of any person who may receive this report, clients should seek the advice of a registered investment advisor and other professional advisors, as applicable, regarding the appropriateness of investing in any securities or any investment strategies discussed or recommended in this report.

This report is for information purposes only and is neither a solicitation for the purchase of securities nor an offer of securities. The information contained in this report has been compiled from sources we believe to be reliable, however, we make no guarantee, representation or warranty, expressed or implied, as to such information's accuracy or completeness. All opinions and estimates contained in this report, whether or not our own, are based on assumptions we believe to be reasonable as of the date of the report and are subject to change without notice.

Please note that, as at the date of this report, the Research Analyst responsible for the recommendations herein, associates of such Analyst and/or other individuals directly involved in the preparation of this report hold securities of some of the issuer(s) referred to directly or through derivatives.

No part of this publication may be reproduced without the express written consent of Odlum Brown Limited. Odlum Brown Limited is a Member-Canadian Investor Protection Fund.