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10 Things You Should Know About Negative Interest Rates

A helpful overview of what negative interest rates are, and why central banks might use them to support economies.

Client Conversations gives financial advisors an easy way to communicate with clients on topics influencing financial markets; it highlights common investor behaviors and offers ways to address the challenges investors face. Share this article with your clients, and remember to follow your firm's policies that govern sharing content with clients and prospects.

Client Conversations gives financial advisors an easy way to communicate with clients on topics influencing financial markets; it highlights common investor behaviors and offers ways to address the challenges investors face. Share this article with your clients, and remember to follow your firm's policies that govern sharing content with clients and prospects.


 

A central bank is responsible for setting a nation’s monetary policy. To encourage lending and spending, the US Federal Reserve (Fed) has set interest rates at nearly zero to make borrowing inexpensive. But to support the economy even more through the COVID-19 pandemic, there’s debate about whether the Fed should introduce a controversial policy—negative interest rates—to incentivize spending that much more. 

It’s all about reaching goals: A central bank’s ultimate goals are to keep the country’s currency and economy stable and to maintain a healthy employment rate. By raising or lowering interest rates, central banks such as the Fed can impact those goals by influencing a country’s money supply. 

A tool that works two ways: If the Fed is concerned that rapid economic growth will lead to high inflation, it can raise interest rates—make it more expensive to borrow money—in an effort to slow spending. If the economy needs support, lowering rates can help encourage spending and business investment. For example, the Fed reduced rates to near zero after the Global Financial Crisis, started raising them in 2015 as the economy’s recovery took hold, then lowered them again during the COVID-19 pandemic when the economy shut down.

Desperate measures: In extreme circumstances, central banks can even push interest rates below zero. While they’ve never been used in the US, the European Central Bank and the Bank of Japan have had negative interest rates for several years as part of their recovery from the Global Financial Crisis. 

Isn’t it automatically bad when something is negative? In theory, negative rates are meant to keep money flowing in the economy by making it more beneficial to spend money than to save it. Another way of looking at it is a little pain now in exchange for a potential long-term gain in the form of an economy that keeps growing. 

So wait, negative rates can actually be a good thing? Negative rates could be beneficial for businesses and some consumers since it drives the interest rates on mortgages and loans to rock bottom—or even pays them to borrow money. Essentially, negative rates make for a good time to invest in big purchases that need to be financed.

But not everyone benefits: Banks may choose to eat the cost of negative rates rather than pass it on to consumers as a fee for depositing money with them. But even so, interest rates would be so low that savers could actually lose money by keeping it in the bank, especially after factoring in inflation. Bondholders may also lose out—a bond with a negative yield wouldn’t pay back enough interest to cover the original purchase price. 

However, bonds would still be an important investment: Even if rates in the US were negative, US government debt is still considered a high-quality, “safe haven” investment. Low or negative rates don’t negate creditworthiness.

Negative rates abroad could actually pay for US investors: There’s currently more than $12 trillion of negative-yielding debt in global markets.1 But professional money managers may have the skill and experience to turn that negative into a positive by applying currency hedging to potentially generate positive returns for US bond investors (see FIGURE 1 below).

You won’t find negative rates in your macroeconomic textbook: There’s debate as to the effectiveness of negative rates. It’s a very modern strategy—in 2014 the European Central Bank was the first to cut short-term rates below zero. With such a limited history, it’s difficult to determine whether or not it’s been effective, making it a somewhat controversial tactic.

Unlikely to happen here, but worth understanding what the fuss is about: The Fed has consistently opposed pushing rates below zero. In light of Europe and Japan’s experience, the concern is that the risks outweigh the reward in the US: Both banks and consumers could be too negatively impacted to reap the potential long-term benefits.

Figure 1

Five-Year Government-Debt Yields Tend to Improve When Hedged to US Dollars

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Past performance does not guarantee future results. Sources: Bloomberg and Wellington. Data as of 3/31/2020. 

Talk to your financial advisor about how changing interest rates can impact your individual situation.  





1 Source: Bloomberg Barclays Global Aggregate Negative Yielding Debt Index as of 5/31/20

Important Risks
:  Investing involves risk, including the possible loss of principal. Security prices fluctuate in value depending on general market and economic conditions and the prospects of individual companies. • Fixed income security risks include credit, liquidity, call, duration, and interest-rate risk. As interest rates rise, bond prices generally fall. • Foreign investments may be more volatile and less liquid than U.S. investments and are subject to the risk of currency fluctuations and adverse political and economic developments.

This information should not be considered investment advice or a recommendation to buy/sell any security. In addition, it does not take into account the specific investment objectives, tax and financial condition of any specific person. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. This material and/or its contents are current at the time of writing and are subject to change without notice.     

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