November 4, 2019

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What are Negative Interest Rates and What do they mean?

November 4, 2019

 

The financial press has for some time been reporting on the appearance of negative interest rates. Negative rate debt has been around in Europe since 2009, but recently has expanded rapidly. By 2017 European countries plus Japan had created some $9.5 trillion in government debt with negative yields. Recent estimates place negative debt at $16.4 trillion. European countries have expanded their negative debt with some major countries such as Germany, Denmark and Netherlands, so they are now totally negative for all debt maturities.

 

A simple example of how negative yields work looks like this;  An investor buys a one year German treasury bill and pays 101.00 Euros.  At the end of the year the note matures at par – meaning the investor receives back 100 euros so that in effect the investor has paid 1% for the privilege of investing in the note.  How does it work with mortgages?  Borrowers continue to make their monthly repayment, but the outstanding mortgage debt is reduced by more than the payment made.

 

The basic objective of negative rates is to encourage borrowing for the purpose of spurring economic activity. 

 

The central banks of Europe and Japan are worried about deflation. Deflation is considered much more of a threat to economic well being than inflation.

 

While negative rates have yet to come to North America, it is important to recognize the risk they represent.

 

Savers and saving institutions will have a hard time meeting their return objectives unless they are willing to increase their risk tolerances. In many cases institutions who are investing for  pensioners are required by law to buy government debt. How can they cover future liabilities with negative returns? Saving institutions such as the banks will see margins reduced to the point that savers will have to be charged on deposits to keep the banks solvent. So far there is no evidence that negative rates will spread beyond Europe and Japan. In the interim, funds that can move are moving from the negative markets to real return markets such as North America. This is draining investment funds out of the negative market areas - exactly what authorities do not want. Hopefully this experiment in negative rates will soon end.

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