With Negative Interest Rates, All That Glisters Is Not Gold

Remember when central bankers had the world convinced that quantitative easing (QE) was the solution to sluggish economic growth? Well, the proof of the pudding is in the eating and after years of QE in many countries, there is considerable evidence that QE has hurt growth rather than helped it.

Today, central bankers are starting to talk about a new cure-all solution – negative interest rates. Their thinking goes something like this: QE hasn’t worked because all of the new money it created isn’t actively circulating throughout the economies that it was supposed to help stimulate (referred to by economists as low monetary velocity). If negative interest rates manage to force that money off of the banks’ bulging balance sheets, growth will pick up and this will lead to increased investment in capacity expansion and productivity enhancements that will fuel further growth, creating a self-reinforcing cycle of positive momentum that will help struggling economies reach ‘escape velocity’. This improvement in growth should also lead to higher inflation, which would then accelerate spending and investment momentum further by raising the cost of delay.

At least that is the idea.

Central bankers certainly aren’t dummies and their theories are based on detailed, serious thinking. But theories rarely play out in practice the way they do on paper.  That is why QE didn’t work as planned – and why negative interest rates aren’t likely to do so either.

The negative interest-rate experiment is already well underway. German bond yields first went negative back in January 2012 when Germany sold six-month bills at auction for a little less than 0%, basically because it could. The theory behind this development was that investors were willing to accept a negative yield on German government paper because they were speculating that the euro zone would break up and that German bonds initially issued in euros would be converted to Deutschmarks that would trade at a significant premium (once Germany’s economy decoupled from its weaker euro zone counterparts).

Other countries, such as Sweden, Switzerland and Denmark also adopted negative interest rates to defend their currencies from rapid appreciation against the euro. The European Central Bank (ECB) adopted negative interest rates a year and a half ago to try to force idle reserves back into circulation in an effort to stimulate the euro-zone economy and to avoid QE (which it eventually adopted anyway). A few weeks ago, the Bank of Japan announced that it would also charge institutions for the privilege of parking excess reserves with the Bank, and central bankers around the world have openly speculated about invoking negative interest rates if circumstances warrant.

We are now starting the middle innings of the negative interest-rate experiment. Ian McGugan at the Globe and Mail reported last Friday that “an astounding 27 percent of the global government bond market is now trading at sub zero rates”. Just as with QE though, negative interest rates have come with many negative side effects:

• The developed world is aging rapidly and older populations rely on savings for their income. Negative interest rates take income away from savers, an increasing number of whom are past working age, and as such, have limited ability to make up for that lost income. Desperate savers often take on riskier investments in response, but this forced shift in investment demand distorts risk-based pricing and leaves retirees particularly vulnerable to market volatility.
• So far, negative interest rates have not stimulated spending and lending, as was hoped. Instead, this extension of unconventional monetary policy is hurting business and consumer confidence and far from increasing spending, it has actually corresponded with a rise in household saving rates as people opt to keep more of their powder dry for what may come later. That’s because the continued adoption of these unconventional monetary policies has made our central bankers look desperate, and market watchers understand that each new measure further limits the options available to our policy makers when the next crisis hits.
• Negative interest rates should devalue currencies, although that didn’t happen right away when Japan recently announced its move to negative rates, and while that makes a country’s exports more competitive, it does so by stealing demand from other countries, who then respond with devaluation measures of their own. As such, negative interest rates are fueling an ongoing currency war between some of the world’s largest economies. This race to the bottom could destabilize the global economy and, even in a best case scenario, would yield no net gains in the bargain because countries are just stealing each other’s export demand.

Central bankers would probably admit that negative interest rates are the least unattractive of the monetary-policy options left to them, and that a fiscal response from their respective governments would be far more appropriate. But politicians aren’t known for their courage and central bankers don’t need to run for election, so we find the latter using blunt tools to try to make up for the intransigence of the latter.

What we are left with is a patchwork of unconventional monetary policies where one major intervention (QE) has necessitated another (negative rates) to shore up its weaknesses. Does anyone think that this cycle will end there?

At this point as a reader of my blog about factors around the world that affect Canadian mortgage rates, you may be wondering whether these ongoing monetary experiments mean that negative mortgage rates may be coming soon to a broker near you. Alas, I don’t think our lenders will be paying us to borrow from them any time soon, but the way things are evolving, we probably shouldn’t completely rule out the possibility.

Five-year Government of Canada bond yields rose by one basis point last week, closing at 0.60% on Friday. Five-year fixed-rate mortgages are available in the 2.44% to 2.69% range, depending on the terms and conditions that are important to you, and five-year fixed-rate pre-approvals are offered at rates as low as 2.79%.

Five-year variable-rate mortgages are available in the prime minus 0.40% to prime minus 0.30% range, which translates into rates of 2.30% to 2.40% using today’s prime rate of 2.70%.

The Bottom Line: We live in very strange times and the latest proof is that almost one-third of the global bond market now trades at negative interest rates. This quantitative easing by another name is punishing savers, spooking investors, distorting markets and underpinning a global currency war. Of course, it is also helping to keep our mortgage rates low, and against that backdrop, it is hard to imagine rates heading materially higher anytime soon. But let’s not get too enthusiastic about the possibility of negative mortgage rates just yet because by the time we get to that point, we may also be stockpiling water jugs and fighting over can openers.