In addition to sagging economic growth, plunging oil prices, and China hard landing fears, investors are now grappling with a new and more complicated threat: negative interest rates.
In a normal environment, borrowers pay a fee for the use of other people’s money. The amount the borrower pays (the interest rate) is dependent upon the length of time the funds are needed and the probability of paying it back. The fact that a dollar today is worth more than a dollar in the future is a result of the return that one can earn on the dollar by lending it to someone else. It is a fundamental tenet of modern finance.
However, things have turned on their heads as several of the central banks of Europe, and now Japan, are charging banks in their countries for keeping money on deposit. The actions of these central banks have driven interest rates lower on longer term government debt and corporate bonds. 10-year Swiss bonds have a negative interest rate, and even the Swiss food giant, Nestle, was recently able to issue debt at a negative interest rate.
The goal is to force banks to lend more by making it unprofitable to keep funds on deposit at the central bank, and make lending cheaper for businesses and consumers. It should also lower the value of a country’s currency, making its exports more competitive. However, this is a new experiment in modern economics, and the results are unpredictable. Some investors are worried that it could decimate the profitability of the banks by shrinking the spread they earn between collecting deposits and making loans. Others feel that the banks could effectively pass the costs on to depositors by maintaining a positive rate, but charging higher fees. Would consumers be willing to pay to have their funds kept at a bank, as opposed to in a mattress? Most people believe consumers would accept a small fee for the convenience and security of the banking system.
Beyond the immediate impact to the banks, the pervasiveness of negative interest rates could have a significant impact on consumer behavior over time. Imagine if you had to pay someone for the privilege of borrowing money from you! How might that impact your willingness to lend or your desire to borrow? Would you leave your cash in a bank, or would you invest it in things that actually generated a positive return? These are some of the many questions that arise.
In the U.S., the spectre of negative interest rates remains a long way off . Despite the recent decline, our bond yields remain among the highest throughout developed market countries. Fed Chair Yellen also indicated her aversion to negative interest rates in her testimony last week. Nonetheless, with financial markets on edge, investors now have another thing to worry about.
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