Negative interest rates explained

By David Thomas on September 19, 2016
Estimated reading time: 3 minutes

How negative interest rates force us to rethink the appeal of stocks, bonds and savings

If the idea of negative interest rates sounds screwed up to you, it should. On the one hand we have central bankers in Europe and Japan lowering their lending rates into negative territory, which means they charge the major banks money just to hold their reserves overnight. (Think of it as a stick to incentivize the banks to stoke economic activity by lending that money to businesses and consumers instead.) On the other hand, we have bonds trading at negative yields, so investors who buy bonds are willing to pay $100 for the right to be paid back $98 later.

Find the perfect mix of Canadian equities

So far, it’s a foreign thing; we do not have Canadian bonds trading at negative yields. Avery Shenfeld, CIBC World Market’s chief economist, says he doesn’t see bond yields going negative here unless the Bank of Canada takes its overnight lending rate negative. (Keep in mind, the rate is already near zero at 0.5% and late last year central bankers flagged the possibility we could soon follow the Swiss, Swedes, Danes, Japanese and Euro bloc into negative territory. All it would take is a fresh shock to the financial system.)

What does all this mean to us as investors, borrowers or savers? First, do not expect to make money from your bank. Typically, when central banks cut rates the stimulus gets passed on to businesses and consumers in the form of lower borrowing rates. That effect peters out when central banks cut toward zero. No, your bank is never going to give you a negative rate on your mortgage or line of credit; in fact, fees and mortgages are more likely to go up as banks try to cover rising costs. It’s called sharing the pain and some European banks are already charging customers on their ‘savings’ balances.

You might ask why central banks are even making this bold, unprecedented ‘experiment’ in monetary stimulus. The reality is it’s more like a desperation ploy: If they can’t stoke inflation they risk allowing deflation, where businesses slow hiring or cut staff and investment, while consumers hold back on purchases.

Right now, looser monetary policy offers compelling reasons to expect more gains for bonds and stocks, even if the risks are rising. Problem is, there are no precedents; even Warren Buffett admits he hasn’t a clue how markets could respond. This is a new, and unsettling, era.

Some pundits say tiny or negative yields could trigger major flows into stocks and alternative assets like housing or gold. We’re not making those calls but we see investors can still make money on negative-yield bonds; you just need to be able to sell them for more than you paid. That makes them a capital gains play, more like a stock. (Some global treasury markets have posted double-digit gains in 2016, even with yields near or below zero. The big winners are traders padding their global gains with currency hedges. Don’t try that at home.)

If interest rates and inflation rise at the same time

Meanwhile, ironically, stocks are being viewed more like bonds. A stable blue chip with a 4% yield will trounce government bond yields even if its stock trades flat. So it’s tempting to see the love-in with dividends continuing, but again we advise caution because valuations could become very stretched and correct sharply.

Your safest bet? Maybe shift a bit of bond exposure into provincial or corporate debt for a yield bump. But otherwise, hold steady and sit on your Couch Potato portfolio because the landscape could shift again as central banks hand the baton to governments to stimulate economies. Fiscal levers (think deficit spending) will become the next “weapon of choice,” says Shenfeld. “Sometimes it’s safer to have the government borrow more, backed by all future taxpayers, than to push individual households to borrow by tempting them with very low rates.” If that brings inflation to life, it’s a new game.