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Quarterly Market Update


In this edition of the BBVA Compass Market Outlook, Mses. Shackelford and Viguier-Galley examine the unconventional negative interest-rate policy (NIRP) and some of the unintended consequences that make the monetary policy so controversial.

1. What is NIRP and what countries have employed this method to stimulate economic growth?

A negative interest rate policy (NIPR) is instituted when central banks charge a negative interest rate to banks within their banking system to counter a subdued inflation outlook or currency appreciation pressures. The policies are currently implemented with the intent of reinvigorating economies when other policies have failed. When central banks reduce policy rates (like the Fed funds rate), their objective is to stimulate growth. Lower rates are designed to encourage spending and investment into higher-return (i.e. riskier) investments, and drive down borrowing costs for businesses and consumers. It is a tool central banks have at their disposal, and they are the only body that is authorized to take such action.

Negative interest rate policies are an extreme and unconventional measure of monetary policy and, in the estimation of many financial pundits, the policies of low rate and negative rates have not worked sufficiently given the magnitude of the programs. However, the hope is that the U.S. and other countries are successfully using this tool to keep their economies supported, allowing time for the economy to heal and become self-supporting.

The Swiss National Bank, the Danish Nationalbank, and the Riksbank of Sweden were the first major institutions to venture below zero. The Swiss government ran a negative interest rate regime in the early 1970s to counter its currency appreciation as investors from other parts of the world fled inflation, and in 2009 and 2010, Sweden and, in 2012, Denmark also used negative interest rates to encourage foreigners to move their money elsewhere. In January, 2015, the Swiss National Bank again introduced negative interest rates on sight deposit account balances.

The ECB instituted a negative interest rate regime in 2014 in an attempt to prevent the Eurozone from falling into a deflationary spiral. The ECB bought bonds through QE programs and cut interest rates in order to stimulate lending to such an extent that it pushed the government yield curves of some EU members, including Germany, into negative territory. The Bank of Japan (BOJ) instituted negative rates in January of this year.

Most banks have not as of yet passed on the negative rates to their customers, although a few have begun to charge “wholesale” depositors. And in a low-interest rate environment, a bank service charge on a checking account may exceed the amount of interest earned, essentially creating a negative interest rate.

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2. What are the purported benefits of a NIRP policy?

The primary benefit that central banks seek with low and negative rates is to stimulate growth. Lower interest rates are associated with a weaker currency which helps exporters be more competitive. Decreasing borrowing costs is also supposed to “reflate growth” by incenting consumers and businesses to borrow and invest, thereby supporting economic growth. Central banks hope that the lending mechanism eventually kicks into gear and that corporate investments and individuals’ spending reignite a spark of true economic growth that becomes self-sustaining and not dependent on very low interest rates.

3. What are some of the drawbacks of NIRP?

Many pundits contend that the central banks are only making the debt issue worse as debt levels have ballooned since 2008. In the beginning it was only sovereign debt, but now it has bled into the corporate side. When central banks lower interest rates so aggressively it encourages risk taking. The bulk of the money flows into riskier assets which give investors a higher yield while companies may decide to borrow “cheap money” (increasing their own debt levels) in order to do stock buybacks or pay out more in dividends rather than invest in their businesses or the economy. This raises the question of whether or not the central banks’ original intent is really being achieved.

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4. What are some of the unintended consequences of a NIRP?

There is a great deal of concern among financial professionals about unintended consequences, and how these consequences play out. Risk taking is the largest unintended consequence because the basic premise is that in a negative interest rate environment, bad loans could be made. When money is cheap, not only at banks but in the capital markets, companies will issue debt and may not always make sound business investments; the overinvestment in shale oil exploration is to some extent a result of “cheaply available funds”.

Another unintended consequence is that currencies may not behave as central banks had anticipated. If a country has a negative interest rate and their entire yield curve on government debt is negative out to 10 years, then you would expect their currency to decline in value relative to the U.S. dollar or another currency that still has positive carry from interest rates. Last year we saw some of this because the Fed was expected to raise interest rates multiple times leading the U.S. dollar to appreciate. But now that the Fed has backed off a more aggressive rate increase schedule, all the cutting in the world by the ECB and Japan has not made their currencies depreciate much relative to the greenback. On the contrary, the currencies have appreciated which would tend to hurt their competitive positions as their exports become more expensive. In reality, the policy may create deflation by decreasing the velocity of money in the system, as people start preferring to hold cash rather than deposit it.

Economic Outlook

Economic Outlook

Another unintended consequence is that because investors are not earning interest at the banks, those that are smart enough not to take on more risk than they can stomach, are forced to save more in order to achieve their future financial goals. So instead of spending money, they are saving more, and savings rates have gone up. The savings rate of Americans who were considered to be the world’s biggest spenders has gone up to almost 6%.

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While investors understand the situation, they are also desperate to earn a return on their investments. Therefore, one of the greatest unintended risks is that it leads to risk taking not only at the corporate level, but also at the individual level. It is a continuation of a long- standing problem that arises when investors seek income, but one that has been exacerbated by low and negative rates. The industry has crossed a threshold that most never envisioned. The mantra was once that investments could only go to zero – it was not in our psyche to go negative, or that if we held a bond to maturity that we would not get all of our money back. That is no longer the case for investors who buy bonds with negative yields and hold to maturity.

For now, individual investors have remained insulated from the direct effect of negative rates but another unintended consequence of negative rates is the drop in what economists refer to as the velocity of money ( the speed at which money circulates through the economy). People start taking their money out of the banking system and buy other stores of value like gold or real estate. A decline in the velocity of money increases deflationary pressures. Each dollar (or yen or euro) generates less and less economic activity, so more and more money is put into the system to try to generate growth.

5. In your opinion, is the employment of negative interest rate policies reaching a conclusion?

We really do not know what the natural conclusion of negative interest rate regimes are, or will be. These are unorthodox measures and a new form of experiment which has not been seen before at this scale – the outcome could be predominantly bad, or good, or somewhere in between.

The Fed should hold steady and continue to raise rates even if it hurts the economy or the stock market in the short term. At some point the Fed must begin to curtail the ability to take risk and create a valuation bubble whether in stocks, high yield bonds, or wherever capital is flowing.

But while the government continues to leverage up, others including well- managed municipalities have deleveraged - lowered their debt because they were forced to do so after 2008. The successful ones have very lean balance sheets.

Consumers have also deleveraged. It is important that consumers not be overly leveraged, because it takes away their flexibility to manage through a crisis or a problem. So municipalities and consumers in the U.S. have done a good job. Central banks and governments have loaded up the debt wagon in an effort to support their economies, but monetary policies can only go so far without structural reforms (fiscal and regulatory) to support long term growth and adapt to an aging world. Pendulum swings sometimes go too far, and this one is probably still swinging. It is difficult to say when or where it stops. This is the reality of the investment landscape, and as an investor, we are attempting to navigate this world. Markets inflate on the lower interest rate environment, but the important question is the fundamentals that lie underneath. That is why it is so important to own good quality companies, to understand the true cash flows, the debt repayments’ ability, and who is borrowing to do stock buybacks or borrowing to make investments, and whether those are sound investments or bad ones available just because they were cheap. Companies with solid businesses, good franchises and returns on equity, strong balance sheets and cash flows, are most often the companies that can survive if something goes wrong. That is the reason we have always bought and will continue to buy quality equities and corporate debt.

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Other Sources: Bloomberg;;; First page index returns are calculated on a total return basis using the following indexes: S&P 500 (SPX), MSCI World (MXWO), MSCI Emerging Markets (MXEF), Bloomberg 7-10 Year U.S. Treasury Index (USG4TR), Morningstar U.S. Agency Bond TR Index (MSBIUATR), Municipal Bond Buyer 40 Index (BBMIRNEW), Credit Suisse High Yield Index (CSHY), MSCI U.S. REIT Index (RMZ Index).