Authors: Akhil Majithia Co-VP Education/ Research, Joseph Whibbs Co-VP Education/ Research, Amy Li Research Analyst, Ian Cheung Research Analyst
- The European Central Bank cut its interest rate by 10 B.P. in September to a record low of -0.5%
- President Donald Trump tweeted in response saying Fed should follow suit and cut rates below 0% as well
- 5 years after first offering negative interest rate, European banks continue to suffer
What does President Trump’s tweet mean? How is it possible that someone gets paid to borrow money? To answer these questions, we first need to understand what negative interest rates are.
Are Negative Interest Rates to be Feared?
Historically, borrowers paid interest to lenders; that is until the European Central Bank lowered the rate on its credit facility to -0.10% in 2014. This represented the first time interest rates went negative in recent history, meaning that some lenders are now paying borrowers to take their money. Many central banks cut interest rates to zero in response to the 2008 global financial crisis. After a decade, interest rates have remained consistently low across the world due to moderate economic growth. Cutting interest rates to zero in some cases has not been enough to achieve the stimulus effect desired, so some major central banks have chosen to practice a negative rate policy in an attempt to encourage borrowing and penalize those who hold on to excess cash. Countries such as Switzerland, Denmark, Sweden and Japan now have rates slightly below zero. In these negative interest environments, the price people pay for a bond today is greater than the sum of the face value that will be received when it matures plus the interest. Investors lose money when they buy a negative-yield bond and hold it to maturity. It may seem odd to do so but there are several reasons that this strategy has been employed. First, with a high degree of market uncertainty and worries of impending recession, market decline, or a further reduction in interest rates, investors can choose to accept a limited loss by holding on to a bond with a negative-yield. They are getting less than what they put into but at least the future loss is certain. Investing in bonds with negative yield is still much less risky than investing in other securities. Second, investors choose not to hold onto cash instead because of the expectation of currency deflation. This implies that if investors are anticipating deflation, it is reasonable to buy a negative-yield bond instead of hold on to cash because the purchasing power of the repaid principal is going to rise..Third, investors believe that interest rates will continue to decline. This will give investors a profit as the price of bonds will increase to reflect the further declines in interest rates. With today’s negative rates in Europe and Japan, what is this signaling? Is there a deflation ahead of us? What are the lenders’ view on the time value of money? It is clear that central banks in Europe and Japan want to stimulate their economies with negative rates. However, will this policy succeed? It is worth pointing out that the pessimistic signals sent by negative rates may have a contractionary effect. Research has shown that the negative rate environment creates uncertainty for consumers and they are starting to save more with the knowledge that they will be getting less than what they put into the bank. Negative rates can also disrupt floating-rate instruments. Lenders and borrowers have been receiving interest rates at a spread over the base rate Euribor. With a negative rate, loans and deposits become less as time passes, which distorts the time value of money principle. Regarding the calculation of discounted present values, negative rates imply that the present value of future pensions is greater than their future value. With low yields and negative rates, this is an unfavorable situation for pension funds as they are looking to find investments to ensure that retirees receive the benefits they were promised.
Now that you have been given an introduction and background of European Central Bank’s negative interest rate, let’s revisit Trump’s tweet.
With European Central Bank’s negative interest rate in place, investors tend to look for higher returns in foreign markets. As a result, intuitively the apparent value of the Euro will decrease, which boosts European exports as Canadian importers could buy more of European goods with the same Canadian dollar. One could argue that Trump is concerned about how the further decrease in negative interest rate will indirectly reduce America’s export and ultimately lower the profitability for some US companies.
Expected impact of European Central Bank’s Negative Interest Rate
As the primary objective of the central bank in announce a negative interest rate was to incentivize consumer spending, the current situation is beneficial for most buyers in the UK. For instance, new home owners are able to secure a lower borrowing cost on mortgages, and it is considerably easier for students to pay off their current tuition debts.
Commercial banks in Europe continue to suffer as their net interest margin further decrease. Negative interest rates act as a charge for commercial banks to deposit money in the European Central Bank. If the commercial banks in turn do the same thing to their customers to compensate for their additional charge, they risk customers’ retrieval of their deposit at the bank. Instead, commercial banks look to cut costs elsewhere, as shown by the recent employee layoffs at Deutsche Bank and UBS.
For investors: concerns and opportunities
In today’s intertwined global market, market occurrences in Europe great impact on retail investors, wealth preservers and speculators in Canada. Therefore, it is worthwhile to question the various threats and opportunities. For example, value investors have a good opportunity to enter the market if they believe that the European Financial sector is undervalued because of the negative outlook of the entire market. In addition, investors that believe that negative interest rates will indeed stimulate European customer spending and increase profits for certain companies can potentially long dividend stocks of those companies.