Sometimes we see things happening in the economy that not even the most brilliant minds could have foreseen…
Up until recently low interest rates were rare, a zero rate was a topic for theoretical discussion, and below zero interest rates were a matter for a parallel universe.
Negative interest rates in particular have puzzled many economists. In normal times, private banks deposit money at a central bank and receive interest on it. This is no different from an individual depositing savings at a private bank. But recently private banks started being charged a ‘parking fee’ for parking their money at central banks.
This can cause a bit of a problem.
You see, when interest rates are above zero, you earn money when you let someone else store your cash for you.
We all understand this.
When interest rates are (close to) zero, you will get more or less the same amount of money back as you handed over.
Again, this makes sense. But, naturally, when interest rates are below zero, you lose money when you lend it out.
Here lies the problem.
Cutting interest rates at a time of economic woe is the oldest trick in the book. If saving doesn’t pay off, people will be more inclined to spend their money. Similarly, if the cost of borrowing goes down, people will be more inclined to spend other people’s money.
In both cases, more money will be pumped into the economy and that is generally considered the best way to reboot the system.
But how do you reboot the system if interest rates are already low?
Indeed, people speak of low interest rates when they fall below two per cent. Just to give you an idea: the 0.5 per cent rate announced by the Bank of England in March 2009 was its lowest rate in over 300 years.
Low interest rates are generally considered an ominous sign. It’s proof that the economy is in bad shape as we only see them when deflation, unemployment, and slow growth are the order of the day.
So a low interest rate means trouble.
But Japan decided to go one step further in the 1990s when it became the first country to set its interest rates at zero. Japan’s asset price bubble had burst and the zero rate was meant to counter the persistent decline in asset prices. Its effectiveness is still up for debate.
Following the most recent global financial crisis in 2008, the US Federal Reserve and a number of European central banks also adopted a zero interest rate, with varying degrees of success. (So far only the US economy seems to have come out stronger after its use.)
The lack of success in the Eurozone of a zero interest rate led the European Central Bank to set its rate below zero last year. This made the ECB the first major central bank to pursue a policy of negative interest rates.
Negative interest rates are merely a symptom of a wider problem: central banks are having a hard time getting the economy back on track. In such a difficult investment climate, low returns are inevitable.
So, if negative interest rates do reach these shores, how could they affect you?
How negative interest rates affect investors
Low, zero, and negative interest rates all point to a difficult economic situation. So, the first question you might ask is: what’s the difference?
For investors low interest rates are no reason to pop the champagne. You can’t really grow your capital anymore simply by leaving your cash in a bank. Though you still might earn a little, it will be nothing in comparison to the interest you receive at normal rates.
People are not forced to take their money out of their savings account. Yet those looking for higher rates of return will start exploring other possibilities.
A zero interest rate already puts more pressure on investors to move their money. The nominal value of their money stays the same, but inflation could cause their wealth to decrease in real terms. It’s not strange that many investors choose to take their money out of the bank and invest it in something a little more daring, like stocks.
What is true for zero interest rates is even truer for rates falling below zero. Investors will certainly make a loss if they don’t act and the urgency of the situation forces them to act swiftly. The path to risky investments will look more appealing.
For this reason you will see investors looking for investment opportunities abroad. This is a natural response. The problem is that most markets are currently in stormy weather. Since it is a global phenomenon, there’s no reason you should expect better returns elsewhere.
How negative interest rates affect homeowners
One man’s meat is another man’s poison. While low interest rates may not be received with cheers by investors, it is considered good news for homeowners.
For most people a mortgage is their biggest financial investment and sinking rates translates into lower monthly payments.
Homeowners with a tracker mortgage benefit the most as their mortgage repayments are subject to market conditions. It’s the reward for sailing the rocky seas of variable interest rates compared to the stability of riding the fixed rate train.
Those with fixed mortgages are more immune to falling and rising interest rates. But even they could gain, as fixed rate mortgages tend to be cheaper when interest rates stay low for a considerable period. This applies for the most part to new homeowners and people refinancing their mortgage.
And then there’s the matter of a new housing bubble that many commentators write about. Low interest rates, let alone negative ones, will seem to many like the perfect time to apply for a mortgage and buy a house. This, in turn, will cause property demand to go up with prices potentially going through the roof.
In the short run, this is clearly positive because people’s homes increase in value. But when that bubble finally bursts, no one stands to gain.
Riding out the storm
There are no history books that explain things that have never happened before. So when it comes to the novel reality of negative interest rates, opinions differ over whether it has a positive or negative impact on markets.
Frankly, by setting negative interest rates central banks are sailing into completely uncharted waters.
Some see this as a sign they are running out of ideas; the financial equivalent of giving a blind, long ball forward at the end of a football match and hoping for the best. Others think it might actually lift up market sentiment as it proves that central banks will stop at nothing to achieve their goal.
Since this has never happened before, the simple truth remains that we don’t know how this will pan out. What we do know is that we are currently living in a world of low returns…
Whether you have invested your money in bonds or stocks, they all have lower than usual or even negative yields at the moment. This means that there is a big chance that you can no longer count on the returns you were hoping for, and perhaps even expecting.
Whenever this happens people have a tendency to become impatient and decide to act. But switching your money around is not without its risks. Sometimes the sensible thing is to be patient, especially when we find ourselves in a new situation without a guidebook.