Negative interest rates: A risky new economic tool?
Setting key rates below zero is being embraced by recession-plagued countries
Imagine depositing funds into a bank account and having the bank charge you to hold the money. Fortunately, this hasn't happened yet, but it could in countries such as Japan, where negative interest rates are being used as an economic tool to stimulate growth.
Setting key interest rates below zero is a relatively new monetary policy practice and one being embraced by recession-plagued countries desperate to jump start their economies. So far, Germany, Sweden, Switzerland, Denmark and Japan have all implemented negative interest rates.
Negative interest rates discourage banks from hoarding cash and in theory, stimulate lending to businesses and households instead. They also push investors into riskier assets by making bonds a much less attractive option.
For example, investing in a $50,000, five-year bond in Germany, Japan, or Switzerland would yield less than your original investment when it matures in 2021. In the United States, that same 5-year bond would pay you just 1 percent in interest, but you would at least receive your principal back at maturity.
Bloomberg estimates that nearly 25 percent of the global government bond market is trading with negative yields. By comparison, investing in real estate and stocks has been a much better way to gain higher returns.
Negative interest rates not only drive investment in riskier assets, but they also help weaken currencies and prompt export growth as a result. A weaker currency helps make exports cheaper to sell overseas, which in turn drives up corporate profits.
Central banks are also increasingly turning to negative interest rates to help keep deflation in check by increasing inflation. Deflation is anathema for companies because they have no pricing power. If consumers can buy something cheaper in six months, they will wait to buy. Japan has been suffering deflation for two decades for exactly this reason. Some inflation is good for the economy.
It's too soon to determine if the negative interest rate policy is achieving its desired effect. Japan, for example, just sold its first negative yielding bonds in January. In Europe, where negative interest rates have been in place longer, stock markets have improved, exports are picking up and high unemployment rates have come down a bit.
For our clients, we see negative interest rates as a potential benefit, since negative-yielding sovereign bonds spur investors to buy the dividend-growth firms we hold in our model portfolio in order to achieve positive cash flow. As a result, there is also more motivation for CEOs to continue to pay and increase their dividends.
Would the United States ever adopt a negative interest rate policy? Current Federal Reserve Board Chairwoman Janet Yellen was asked this very question last November and while she didn't think it would occur any time soon, she didn't rule it out either. If the financial crisis of 2008-2010 taught us anything, it is to expect the unexpected in a time of severe crisis.