What's with all the negative interest rate talk again?
We brought up the topic of negative yields a year ago, when bond yields in Switzerland fell below zero, followed by a similar occurrence in several other European fixed income markets. The first type of negative yield concerned secondary market bonds, where underlying prices moved high enough over par to push the yields-to-maturity so low (remember the teeter-totter of yields and prices having an inverse relationship) that these actually dipped below zero. How this works is, while the
Negative interest rates from a central bank policy standpoint is a bit different. In the simplest explanation, this happens when the a target
Either way, why do this? The updated part of the answer is that negative rates are an enhanced stimulus, used by central banks when a zero rate policy doesn't seem to be effective enough. For the most part, as noted earlier, it takes the form of an operational/banking consideration. It's counterintuitive to the basic understanding of how banks usually operate, so can be a challenge to wrap one's head around. When you have zero interest rates, rather than rewarding saving (through a regular, positive interest rate), instead you're attempting to push banks, savers and other low-risk investors further out on the risk curve—toward higher-risk investments and loans. It also perpetuates incentives to borrow and take on leverage at extremely low levels, by pulling credit spreads further down. If this isn't enough, and it may not be
Will it happen in the U.S.? It's difficult to say. In recent comments, members of the FOMC have mentioned the idea several
This concept seems nonsensical to some, but central banks feel there are other side benefits from a negative interest rate. A key one is as a tool to depreciate outright or just suppress the strength of a currency, versus weaker currencies of competing global trading partners. From a currency valuation perspective, being the one nation with positive interest rates in a sea of negative yields creates a carry opportunity that could further exacerbate dollar strength. This might be the ultimate impact of the 'currency wars' discussed so much over the last several years—the race to deflate currencies to enhance exports at the expense of trading partners. As we know, having a weaker currency benefits and a stronger currency penalizes exports—the latter of which the U.S. has been suffering from as of late.
On the negative side, perception could be one of the biggest downsides to the implementation of negative rates—if viewed as a sign of desperation by a central bank with no other ammunition left. After all, when interest rates move to zero, the traditional monetary policy function carried out through the tightening/easing of short-term interest rates no longer works. Key global central banks had already gone through that process, bringing rates to near zero; then came quantitative easing, which included the buying of bonds further out on the yield curve to synthetically manipulate other key rates (those tied to rates for capital goods/autos/home mortgages—QE policy has either been effective or ineffective, based on whom you ask). Negative rates become a more difficult third step, which is why the idea is so controversial.
While negative rates don't appear likely at this point in time in the U.S., as long as GDP growth remains where it is in the 2's, anything is possible. Conditions remain, as Fed members say, 'data dependent'. Debate continues to surround the issue.
Read our Weekly Review for February 29, 2016.
Read the previous Question of the Week for February 16, 2015.