Negative Rates: Five Lessons Learned - Wells Fargo Investment Institute

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Negative Rates: Five Lessons Learned

Wells Fargo Investment Institute - September 24, 2020

by Brian Rehling, CFA, Head of Global Fixed Income Strategy

Key takeaways

  • Global economic growth and inflation at low levels has been a reality since the Great Financial Crisis of 2008.
  • As a result, central bankers have instituted extraordinary monetary policies to combat these concerning trends.
  • In an ongoing series, we take a look at the investor implications of these policies.

In many countries, interest rates have reached into negative territory as policy makers try to spark economic activity. Central banks may not be done yet, as the Bank of England is preparing to employ negative rates if needed. Today, a large volume of sovereign and corporate bonds overseas offer a negative yield to maturity. Recently the Federal Reserve (Fed) indicated that short-term rates would remain extraordinarily low for years to come. Given our expectation of a continued economic recovery, we do not expect a widespread negative rate environment domestically. 

However, a new unexpected shock to markets or an economy that fails to recover as expected could challenge domestic policymakers desire to avoid negative rates. Negative rates — whether engineered by the Fed or realized by the markets — could have profound consequences. Below, we look at five lessons learned from countries that have experienced a negative-rate environment and what such an environment could mean if it were to occur in the U.S.

1: Negative rates have failed to lift inflation expectations

Inflation — typically a dirty word for central bankers — has become an objective that most have been unable to fulfill. As a result, bankers have had to change their focus from fighting inflation to fighting anemic inflation or even outright disinflation. While inflation can largely be fought with higher interest rates, disinflation has proven to be a more complex enemy to combat. If central banks are unable to increase inflation and inflation expectations, consumers may slow spending, choosing to wait for lower future prices, further entrenching the enemy that is disinflation.

In an attempt to get out of the disinflationary cycle central banks have expanded their monetary toolbox; bond purchases (quantitative easing), new lending programs and in some countries negative rate policies are just some of the new tools that have been tried to lift both growth and inflation expectations. Negative policy rates seemed rather intuitive – after all if you raise rates to combat inflation then surely lowering rates as far as needed, even into negative territory would lift inflation. Central bankers hypothesized that negative interest rates would encourage borrowing, leading to higher bank lending and ultimately an increased in demand for goods and services. Unfortunately, the expected increases in growth and inflation have failed to materialize.

Chart 1. The federal funds rate was increased to fight high inflation; lowering the federal funds rate has not increased inflation

Chart 1. The federal funds rate was increased to fight high inflation; lowering the federal funds rate has not increased inflation

Sources: Bloomberg, Wells Fargo Investment Institute, September 21, 2020. PCE: Personal consumption expenditures price index.

Perhaps inflation and growth would be even lower without negative rate policies, but it is without question that central banks have been unable to lift inflation to target goals through negative rate policies alone. In fact, we believe there is some evidence that negative rates have become counterproductive, especially their impact on the financial sector, which has in many cases led to more-limited credit growth. 

2: Negative rates hurt the banking system

Banks facilitate lending, and strong, healthy banks are critical to robust economic growth in developed economies. The nation’s money supply rises or falls as banks lend more or less, this transmission of money through banks is key to understanding the impact of negative interest rates. We anticipate that as rates fall, particularly into negative territory, net interest margin, a primary earning component of bank income compresses. This compression reduces bank earnings and ultimately may limit a bank’s ability to lend. While empirical evidence of such an impact is limited, a paper from Bangor University looked at the impact of negative rates policies on bank performance. The research found that “bank margins and profitability fared worse in Negative Interest Rate Policies (NIRP)-adopter countries than in countries that did not adopt the policy. Specifically, countries in which central banks implemented NIRP experienced a decline in net interest margins and return on assets compared to those countries in which central banks did not follow this policy.”

Research from the European Community Bank (ECB) has found that “banks highly exposed to negative interest rate policy tend to grand more loans.”  This is generally the result of higher risk-taking by lending institutions.

Chart 2. European banks have struggled in a negative rate environment

Chart 2. European banks have struggled in a negative rate environment

Sources: Bloomberg and Wells Fargo Investment Institute. Daily data, January 1, 2013 – September 23, 2019. The deposit rate is one of three policy target rates set by the ECB. Bank relative performance is shown as the ratio of the Euro Stoxx 600 Bank Index to the Euro Stoxx 600 Index, both in euros, and indexed to 100 as of January 1, 2013. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results.

Domestically, the financial sector has lagged broader market performance as rates moved to historically low levels. Given the negative feedback loop often associated with a negative rate environment, we would expect a move to such a policy would likely continue or even accelerate this trend of financial sector underperformance.

Chart 3. Performance of Financial Sector vs. S&P 500 Index since a zero lower bound federal funds rate was first implemented

Chart 3. Performance of Financial Sector vs. S&P 500 Index since a zero lower bound federal funds rate was first implemented

Sources: Bloomberg, Wells Fargo Investment Institute, September 21, 2020. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results.

3. Negative or low rates must be in coordination with fiscal policies to be most effective

We view evidence as ample that central banks, despite seemingly unlimited monetary tools, actually have a limited capacity to defeat disinflation trends on their own. Japan has tried unsuccessfully to lift inflation and economic growth through negative-rate policies for almost five years. More recently, the European Central Bank — despite massive quantitative easing and a negative rate policy — remains unable to achieve desired goals. 

In our opinion, low- and negative-rate policies must be coordinated with significant fiscal stimulus to be most effective. Whether a coordinated approach can ultimately allow the economy to generate a more permanent positive growth rate remains unclear, but it has a better chance of success than monetary policy alone. Most developed economies have been loath to support significant fiscal spending commitments as debt levels and budget deficits continue to increase. Undoubtedly, we anticipate that there will be a future price to pay for the rapid accumulation of government debt. Higher government debt levels — which we view as necessary to support monetary stimulus —may increase inflation expectations and revitalize economic growth but could ultimately limit future fiscal options. Limited future fiscal spending flexibility could become problematic during future economic or disinflationary shocks.

With no easy answers, we believe solving today’s economic problems is paramount. Negative-rate policies alone have been unable to turn the tide elsewhere; to have a chance at success, lawmakers must be willing to aggressively support negative- or low-rate monetary policies with fiscal support.

4. Household deposits held at banks are unlikely to move below zero

Household deposits are a key source of stable low cost funding for financial institutions. Experience in Europe, Japan, and elsewhere has shown that banks were unwilling to apply negative rates to household deposits even when other funding rates move into negative territory. Most banks are reliant on a stable deposit base, and anything that could lead to destabilization of those funds is problematic and could lead to a run on a bank. With this in mind, banks will take every effort to maintain a strong deposit base.

Consumers can easily move bank deposits into hard currency, leading to an outflow of deposits from financial institutions should a negative deposit rates on consumer deposits be instituted. For most, holding a currency in physical form comes with a rather limited storage cost; consumers could simply hold cash in a safe, lockbox, or other local storage option. Businesses or institutions have a much more difficult time taking delivery of physical cash due to the sheer size and liquidity required. For this reason, businesses and larger institutions could expect to experience negative returns for short term cash options in a negative-rate environment.

Many investors rely on money market funds to manage liquidity. In the current environment, money market fund yields are very low. In response to the low yield, managers of many Treasury and government money market funds have begun implementing partial fee waivers to maintain a positive yield. Importantly, outside of an unlikely policy shift from the Fed to negative rates, we believe money market fund managers should continue to seek to maintain positive yields. 

Conversely, in what we view as the unlikely scenario in which the Fed would implement a negative rate policy, many managers may have difficulty offering a positive return. In an extended negative-rate environment, we would expect many money market fund yields to eventually turn negative. Prime funds have more flexibility than Treasury and government funds based on the securities they can invest in. Given that flexibility prime funds  may be better able to maintain positive yields in a negative-rate environment but would also likely face significant challenges.

5. Investor implications - Negative rates can lift financial asset prices

Investing in a negative interest rate world can be challenging for investors, especially those that require a stable fixed income stream. Investors may have to make difficult decisions to choose between yield and return or greater stability found in low- or negative-yielding, high-quality, short-term securities. This difficult choice pushes many investors into taking on more risk than they would otherwise be comfortable taking to generate an acceptable level of yield and return. Still, even with these difficult decisions, we look for many of the same tenets of investing hold true in a negative-rate environment, most importantly diversification.

Fixed income: Fixed-income securities, traditionally, have been held for their yield or income in an effort to add stability to the portfolio. In a negative-rate world, the income in fixed income may become challenged, but we conclude bonds can still play a role in portfolios. Negative rates do not necessarily mean negative returns — we see an important difference with a distinction.

  • Corporate bonds should continue to pay a premium over U.S. Treasuries and also exhibit less volatility than equity securities in a negative-rate environment. Moving down the credit spectrum is a viable strategy to increase yield but must be done so with caution. We recommend investors use active management when purchasing lower-quality investments.
  • Investors may also find somewhat higher yields, longer duration, and more equity-like characteristics in preferred securities. While higher-yield expectations in preferred securities may be desirable for many investors, this sector can exhibit unusually high volatility during times of stress. Investors should seek income in this sector with a buy-and-hold mentality.
  • In a negative-rate environment, investors may consider holding emerging market fixed income securities. The higher yield available in this asset class would be attractive, especially those issues denominated in local currency as the potential for a weaker dollar increases should we experience negative interest rates.
  • In order to boost return, investors may consider using bonds to rebalance into equities. In other words, when equity prices fall, investors might consider lightening bond positions to generate cash with which to put into comparatively cheaper equities.
  • While yields are currently very low, for those looking to invest in money market funds, we continue to favor government funds over Treasury funds, given that government funds have more flexibility based on the types of securities in which they can invest.  We also currently favor government funds over prime funds, given the lower risk profile of government funds and the currently tight yield spread between government and prime funds.

Equity markets: In a negative-rate environment, equities are likely to remain volatile as investors question the outlook of future economic and earnings growth. However, we anticipate equities may remain a better source of return than bonds, for several reasons. 

  • There may be a lack of attractive alternatives. With lower yields in fixed-income investments, investors may have to make difficult decisions to move into higher risk securities such as equites to try and generate returns.
  • Fiscal and monetary support are likely in a negative interest rate environment. Low or negative rates can encourage government borrowing while monetary policy makers are more willing to employ creative policies. We would expect these actions to lift financial asset prices, with equities markets likely benefitting.
  • Dividends can become a principal source of income. Over the last two decades, dividends have compounded at rates above consumer price inflation and just below broad equity price returns, but with lower volatility. Between 2007 and 2009, the S&P 500 Index fell by 21.4%, but dividends fell by 17.6%.

Consider alternative markets and means of portfolio selection: Alternatives can offer potential opportunities traditional asset classes are weakening.

  • Investors may benefit from strategies that try to take advantage of distressed credit and falling prices among cyclical equity sectors.
  • For qualified investors, there may be opportunities in private debt or real estate, which take a longer-term view of returns.

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