What do Negative Interest Rates Mean for Investors?
Part 3: Effect on the Economy
Japan’s strong economic growth in the early 20th century ended quickly at the start of the 1990s. A speculative asset price bubble was fuelled when The Plaza Accord doubled the currency value of USD against the yen between 1985 and 1987. BOJ had caused excessive loan growth quotas resulting in increased lending in Japan to lower-quality borrowers than most other countries.
In late 1989, BOJ raised lending rates sharply, which cause the bubble to burst and the stock market to crash. Just like the GFC, equity and most other asset prices fell, resulting in overly leveraged Japanese banks and insurance companies with books full of bad debt. The bail out of institutions from the government, ability to postpone recognition of losses on their financial statements and cheap credit from the BOJ, ultimately turned them into zombie banks.
During the 1990s, Japan’s core inflation had dipped below 1% along with its GDP, which dropped by approximately $1.5t. Japan had implemented a 0% interest rate by this time, but it was too late as deflation had already set in, with the CPI continuing to fall until 2002. Between 1997 and 2004, the BOJ had attempted two rounds of quantitative easing, and the Japanese government had tried nine different stimulus packages to try and stimulate the economy. Despite these unprecedented unique efforts, Japan has had almost no economic growth since these events have taken place.
It was in 2001 when BOJ adopted its first quantitative easing plans, where it purchased Japanese Government Bonds to expand its current account balances which include the bank’s reserves plus currency in circulation. The unprecedented experiment policy lasted for five years before being lifted in 2006. There could not have been any real impact on the economy, since flooding commercial banks with excess reserves would be equivalent of swapping two assets with zero yields.
By 2006 BOJ’s asset holdings had increased from ¥110t to more than ¥150t, which was equivalent to about 30% of Japanese GDP at that time. Core inflation stood at -0.6%, even though the BOJ’s board stated that inflation was on a positive trend. From 2006 to 2013, BOJ implemented a series of smaller QE measures which the BOJ concluded did not have the results they were after. It was in 2013 when BOJ implemented its first QQE policy of which there were several elements:
- Purchasing large JGB’s that would increase the monetary base by ¥60-70t per year
- Lengthening the maturity of JGB holdings in an attempt to lower long-term rates and flatten the yield curve
- Target to stick with the new policy until inflation was at or above 2% target rate.
Just over a year later, the asset purchase commitment was raised to ¥80t. This caused BOJ’s balance sheet to grow rapidly, with holdings rising to ¥140t in 2013 and ¥380 by 2016. By the time it was 2018, its monetary base had stood at roughly 90% of GDP.
There were clear and early signs that this QQE program was working well, with yields on 10-year government bonds falling from 0.75% to about 0.25%. Unemployment also saw a fall signifying well economic health. Moreover, finally, core inflation (excluding food and energy) rose from -0.6% to about 1.2% by 2015. However, core inflation ended up falling back to about 0.5% by 2016, resulting in long-term inflation expectations to fall too. BOJ also held about 40% of the JGB market at this point, and the 10-year yield fell into negative territory. This was when the bank decided to cut rates to -0.1%, which saw the new policy being adapted; YCC.
As banks profitability declines and banks look to hold less depositary reserves, they will shift their focus to other low-risk assets such as government bonds or hybrid securities. Institutions and investors will prefer longer-term bonds over short-term bonds due to their high yield. As a result, short-term bond prices will drop, and their yields will increase due to the sell-off. Eventually, institutions will be forced to allocate their cash to other assets which can include risker assets such as equities, to maintain their profitability. Since equities’ performance is tied to firm profitability, there will be heavy buying and selling of fixed-income securities, banks will lose interest income, and their net interest margin will be squeezed, we can expect extremely high volatility in the stock market.
Circulation of Credit
Circulation of credit is also affected when negative interest rate policies are adopted. It is less costly if retail investors and institutions hold physical cash rather than risk investing or pay for depositing. Reducing the flow of cash in the economy has the same effect of a contractionary government tax hike, reducing bank income and halting income growth. This is exactly what happened in Europe when the ECB decided to cut interest rates into negative territory. The EU financial sector suffered a gross income loss of $600m within months.
Effect on CAPEX
Cutting rates to negative territory is theoretically meant to increase business spending and investing through CAPEX. History shows that corporations instead chose to rather save to cover short term losses and save for expectancy of future income. A study by Macquarie Group shows that CAPEX investments have not recovered to pre-GFC levels in countries who have adopted negative rates. This aspect did work however in the context that corporations increased their lending (but reduced desire to borrow and invest).
Source: Macquarie Group, Datastream
Overall, No Positive Impact?
Theoretically, lower long-term yields should generate some positive economic impacts due to the lower borrowing costs. This lower cost should force people to move from saving to heavier consumption and spending, therefore stimulating the economy. The effects of negative rates on the economy highlights the importance of market sentiment that goes against conventional theory. If households are not particularly optimistic due to lower-income expectations or job insecurity, then increased demand for credit will not increase.
We also see that cutting interest rates to negative has no profound result in terms of capital expenditures in the private sector. The policy’s goals are to encourage businesses to borrow and invest; however, historically, businesses have chosen to save any surplus cash and focus on short term recovery. There was no desire to borrow capital and invest due to uncertainty in future company earnings. In this case, negative interest rates effectively act a form of monetary tightening.
It seems clear that there is a substantial disconnect between theory and practice when it comes to negative rates. Based on the case studies done on Japan and Europe, we see that negative rates negatively impact the banks, markets and economy in general. Not only is there little evidence that the economy will be stimulated in any meaningful way from it, but we also observe long-term deterioration. However, it is important to note that these effects could be isolated events or a biproduct of other factors since the rarity of negative rates throughout history prevents an accurate study on it. Overall, investors should be weary on the magnitude of impact that arises from central banks implementing negative rates.