In a world of unconventional monetary policy, the use of negative interest rates has been the most recent tool used by central banks as they seek to spark growth where other policy measures have failed. Negative rates are essentially interest rates that are set below 0% by central banks with the aim of stimulating growth through increased lending.
Following our analysis, we believe that negative rates are more likely to have a negative impact for economies and will be of little benefit to consumer and business spending.
What are negative rates?
Policy makers, faced with continued uncertainty in the outlook for economic growth, are looking for additional means to stimulate growth and increase lending to businesses and consumers. For now, negative interest rates apply only to banks’ deposits (also known as reserves) at the central bank. However, as we discuss in this article, this does have wider implications for markets, economies and investors.
Our research finds that contrary to the intent, negative interest rates are likely have a negative effect on economies for the following key reasons
What does this mean for the economy?
Act as a ‘tax’ on banks
Decrease deposit rates and increase lending rates
Create incentives that lead to unintended outcomes
Since business spending, particularly capital expenditure, is more closely related to expectations of future income than cost of funds (as per the table below), lower incomes from negative rates are unlikely to improve on these expectations nor drive capital expenditure. Furthermore, the incentive to offset the cost of negative rates (as a result of lower expectations of future incomes) could result in effort diverted to more short term financial market activity to the neglect of longer term business capital expenditure, which is not good for future productivity growth and long term prosperity.
|Correlation comparisons||Private CAPEX growth versus long term interest rates||Private CAPEX growth versus income trend expectations|
Note that correlations that are closer to 1.00 indicate a higher linkage between the factors
Source: Macquarie, Datastream
Overall, the cost of negative interest rates will eventually affect all other sectors and wider parts of the economy, exactly as a tax hike would. Without any increase in expenditure, the impact on the economy will be fundamentally slower growth.
How does it affect markets?
As banks look to hold less reserves in response to negative rates, they will shift from reserves to other low-risk assets such as government bonds. As net demand for these assets increases, prices increase (and bond yields fall).
What this means is that asset prices will likely increase,firstly, for lower-risk fixed income assets such as bonds (see chart below) since they are the asset closest to bank reserves in terms of risk. However, the effect on other assets will depend on whether the ‘chase for yield’ will offset the
impact of income losses – for example, how equities perform will depend on the impact on banking sector profitability.
It is important to note that the increase in asset prices in this scenario is not related to any underlying fundamental factors. It is solely a response to the distortion in incentives caused by negative rates. The end result? Expect more volatility in asset prices.