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The Investing Implications of Negative Interest Rates
BlackRock’s Russ Koesterich and investment strategist Terry Simpson explain how negative interest rates may impact various asset classes.
daniilantiq / Shutterstock
It’s hard to miss all the media mentions lately surrounding negative interest rate policy (NIRP).
A handful of developed countries across the globe–including Japan–have implemented negative interest rates lately, as the chart below shows, and the Federal Reserve (Fed) is analyzing the implications of moving the U.S. Federal Funds rate into negative territory too.
It’s no wonder, then, that many investors are asking how negative rates could impact portfolios.
The technical details of negative interest rates
Simply put, when rates are negative, a depositor (think a retail bank) has to pay a central bank for the benefit of parking cash at the nation’s central bank coffers. Or put another way, negative rates mean lenders pay borrowers for the privilege of lending (think of a bank paying you to take out a mortgage).
The theoretical aim of such policies is that since banks would have to pay to store their cash, they would be motivated to lend any extra cash to businesses and consumers, propelling the economy.
How negative interest rates affect equities, bonds and currencies
While it still remains to be seen whether negative rates will have this intended economic effect, from a portfolio standpoint, negative interest rates are likely to continue impacting various asset classes.
EQUITIES
From a sector standpoint, the banking sector is most vulnerable to negative rates, not only because retail banks have to pay central banks to park their reserves. The sector’s business model is built around borrowing at the short end of the yield curve (think deposits) to lend at the long end (think loans). Since the long end of the curve tends to be anchored from years of quantitative easing purchases, NIRP tends to hurt banks’ profit margins on the short end, especially since many banks are reluctant to charge depositors.
As such, the financial sector has struggled in countries with negative rates and could struggle further. This is one of the reasons why we recently downgraded our view of the global financial sector to neutral.
According to Bloomberg data for Stoxx Europe 600 indices, since the June 2014 introduction of below-zero rates in the eurozone, the region’s retail and housing-related sectors are down in absolute terms -3 percent and 0 percent respectively. But they’re outperforming the European banking sector and the broader European market, which are down -39 percent and -7 percent respectively over the same time period. (As of 2/26/2016)
Meanwhile, from an overall market perspective, negative interest rates should, in theory, function the same way as the lowering of rates to zero percent has since the crisis, benefitting stocks overall. But in practice, this unique round of stimulus may not be as rewarding.
For one, valuations still remain elevated, even amidst this year’s selloff. For instance, via Bloomberg, while the price-to-earnings ratio for the S&P 500 has fallen 5 percent in 2016, it still remains 25 percent higher than it was at the start of 2012. Second, negative interest rates could be seen as an attempt to drag down long-term rates further, but the efficacy of this unconventional policy has had only limited success in encouraging businesses and households to borrow and spend.
Lastly, there’s some evidence that global markets will perform not on the depth of negative rates, but rather on how well communicated the policy is to the public and if it appears to have truly lasting effects for the real global economy. This helps to explain why markets reacted unfavorably to the news out of negative interest rates out of Japan. The negative reaction may also have been because the negative rate only applies to a small percentage of Bank of Japan (BOJ) reserves.
BONDS
Negative rates are a sign of central bankers’ concerns about slowing economic growth and deflation. In such an economic environment, government debt prices are likely to rise, while government debt yields fall (bond prices and yields work inversely). In fact, according to Bloomberg data, as major central banks promised or delivered more stimulus support and interest rate cuts, yields of long-dated government bonds have fallen across the world.
Meanwhile, fixed income credit sectors, such as U.S. high yield and emerging debt, are suffering from idiosyncratic factors such as lower oil prices and slower economic growth, and thus may be more challenged in a period of high market uncertainty. For this reason, we recently suggested investors consider adding back some interest rate exposure into portfolios, as a hedge against equity risk.
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Source: http://etfdailynews.com/2016/03/11/the-investing-implications-of-negative-interest-rates/
