As central banks exhaust their armoury of policy measures to stimulate their economies, negative rates have started to be wielded as a tool in some embattled developed economies struggling to spark growth.
And while this could have some of the same impact as a rate cut in a positive rate environment, it has set some market watchers on edge.
In theory, said PIMCO portfolio managers Nicola Mai and Peder Beck-Friis, negative nominal rates should make individuals and companies save less while spending and investing more.
It should also lead to a depreciating currency, which can improve a country’s competitiveness.
However, in practice there have been three key drawbacks, according to the managers.
The first is that negative rates impair the banking system, as banks start earning less return on their assets.
“As profits decline, banks may issue fewer loans to businesses and households, or raise the interest rate they charge for those loans,” the pair noted. “Lower bank equity prices risk exacerbating these effects.”
Secondly, negative rates create “significant challenges for other parts of the financial system”, including the pension and insurance sectors, said Mai and Beck-Friis.
Nominal returns and minimum income guarantees can be hard to deliver but are more so when rates are negative and don’t generate enough yield, said the managers.
The third drawback is that negative rates may result in more, not less, savings – the so-called ‘money illusion’, whereby investors give greater consideration to the nominal rate rather than real or inflation-adjusted rates.
The asset manager studied five countries and regions – Denmark, the eurozone, Switzerland, Sweden and Japan – to see the broad impact of negative rates on a range of areas.
Its first finding was that negative rates have led to short-term and long-term market rates and a positive impact on risk assets “with stock prices on average rising”. However, bank equity prices did struggle in this environment.
Source: PIMCO
Negative rates also had a positive impact on lending conditions, with banks lowering household and corporate deposit rates and at the same time lowering lending rates.
Meanwhile, the macroeconomic impact seems to have been “positive, but modest”.
The policy is associated with stronger growth although “dispersion has been high” and it has been unsuccessful in lifting inflation expectations.
Nevertheless, with financial market and bank lending conditions loosening and “a slightly improving macro environment”, could the policy be considered a success?
“We don’t think so. Significant trouble is brewing under the surface, especially on the banking front: bank lending rates are declining more rapidly than deposit rates, putting downward pressure on banks’ profit margins,” they said.
“In response, and following the implementation of negative policy rates in some countries, some banks have started to charge negative rates on some deposit accounts, although they remain the exception rather than the rule.”
The squeeze on bank margins means that their contribution to return on assets has diminished.
While banks have benefited from capital gains and improved credit quality associated with negative rates, these are not sustainable sources of profitability.
Performance of indices over 1yr
Source: FE Analytics
“As we have seen in Japan, structural declines in bank profitability are usually associated with depressed equity valuations,” the PIMCO managers said.
“The combination of lower profitability and lower equity prices could be a source of financial instability over time, especially if European growth were to slow down meaningfully once again.”
It’s not just banks that have been affected, with insurers and pension companies struggling to meet nominal returns and minimum income guarantees harder to finance at current rates.
“To make matters worse, these institutions may not have hedged their liabilities in full to absorb any interest rate changes, jeopardising their ability to meet future payouts,” they said.
“Persistent low rates could lead to instability in these sectors and potentially call for capital injections into corporate pension plans and insurance companies over time.”
As such, there may not be much more room for the policy left to run, according to the managers.
“Looking ahead, it is possible that the European Central Bank will lower rates a little further, but market expectations of another five basis points are close to the maximum we expect,” said Mai and Beck-Friis.
“In the US and the UK, negative rates seem unlikely, given policymakers’ doubts on its effectiveness and political resistance to the concept.
“If policy rates in the US and the UK ever go to zero, and more accommodation is needed, these central banks would most likely focus on quantitative easing and other measures other than negative rates.”
And on a global level, said the pair, negative rates could exacerbate political accusations of currency manipulation, which would not be particularly welcome with trade tensions as they are.
As such the managers are finding favour in US duration assets over Europe and Japan as US rates have further to fall.
Persistently low or negative rates along with expanding central bank balance sheets should also be supportive of risk assets for some time “as investors are forced to ‘reach for yield’.
“However, already inflated risk valuations suggest that it is important to be selective, leading us to take a cautious stance overall,” they said.
“Crucially, low or negative rates will continue to weigh on bank profits. While this is likely to hurt bank equity valuations, it should not meaningfully affect bank bond valuations for now, given the sector’s generally healthier capital cushions and better regulation following the 2007-08 financial crisis.”