OB Report
November 2019
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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.

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