February 26, 2016

Evidence of slowing global economic growth and heightened market volatility has investors increasingly on edge.  After a harrowing start for the markets in the new year, talk of recession risk is rampant and Wall Street analysts are rushing to put out commentary on what the potential downside is to their sectors in the event of recession.  Global central bankers, in turn, are providing reassurances that they stand ready to provide world economies additional stimulus if needed.  Most recently the Bank of Japan introduced negative rates, joining others like the ECB, Switzerland, Denmark and Sweden, in hopes of igniting growth and some inflation in Japan’s anemic economy.  Naturally, investor attention has now turned to the Fed, questioning whether our central bankers would contemplate going down a similar path.

In theory, negative interest rates should work.  If given the option of losing money on savings in what were previously risk free assets or spending those dollars (or yen or euros) today, a rational person may choose the latter.  Borrowing costs would be lowered and banks more apt to lend out excess reserves on which they otherwise would have to pay to deposit with the Federal Reserve.  With so much liquidity sloshing around the system, expectations for inflation should also rise, meeting another key policy goal of central banks around the world.  If low rates are good, how can negative rates not be even better?

That’s simply theory, however.  The reality may be far different.  We see several hidden risks and unintended consequences which may render the actual experience with negative rates far less effective than theory would suggest.  Some of them are:

  1. Savers are punished and expectations of future returns may be lowered, resulting in higher savings rather than increased borrowing/spending.
  2. They eliminate investment vehicles that were previously deemed “risk-free”.
  3. They may set off competitive currency devaluations and volatility (aka beggar-thy-neighbor policies).
  4. Negative interest rates may prompt investors to redeem money market funds which may decrease demand for short-term bonds, potentially pushing short-term interest rates up, in contrast to central banks’ goal to keep short rates low.
  5. They create uncertainty about bank/financial sector profitability which may result in higher borrowing rates as bank spreads widen out.

Like QE, which in our mind failed to spur the economic recovery to levels previously anticipated and desired, we think negative interest rates are yet another unproven policy tool that may ultimately cause more harm than good.  Indeed, based on market gyrations in recent days one could easily come to the conclusion that the very talk about negative rates has caused a loss of confidence in central bankers and resulted in the very market volatility they hope to suppress.