The Dangers of Negative Interest Rates

Are negative interest rates really good for treasurers, and for the world economy in general? There are admittedly some benefits, but there are many more drawbacks. Perhaps a return to zero rates would bring the greatest overall benefit.

 
A few years ago, the unthinkable happened: negative interest rates were introduced. Investors could no longer rely on financial dogmas alone. Financial manuals had to be revisited because financial principles had fundamentally changed. Policies such as Quantitative Easing (QE) were practised by central banks. But what does all this mean in the real world?

There are both positive and negative consequences of these below-zero interest rates for the euro. On the plus side, governments can or should deleverage, or to be more precise, they should ease debt service (deficits have risen since the crisis, but the cost of debt has fallen thanks to negative rates). Corporates were able to take the opportunity to gradually deleverage and restructure their debt. For example, the telecoms and mass media company Altice has been able to reduce its cost of debt by $700m per year.

According to the International Monetary Fund (IMF), costs of financing have reached their lowest level since 1975. Distributed dividends have increased (prior to the Covid-19 crisis), sometimes quite dramatically, or share buy-back programmes have been (re)launched, because companies did not want to accumulate cash and destroy value. No shareholder will complain. The attraction of cryptocurrencies, which do not generate interest (but do not cost either) has increased, despite their volatility. Low rates also generate interest in alternative products (funds) and so-called dynamic investment products - and corporates are revisiting their policies to allow investment in other asset management instruments. Lastly, these negative rates have allowed many people to acquire a house at a more attractive price.

However, these very cheap rates also have disadvantages. For starters, they are potentially creating a dangerous real estate bubble. When bubbles burst, the consequences can be dramatic. We can now borrow for 20 years at less than 1%. This below-zero percent environment has become extremely difficult for banks. Although they try to limit benefit from negative rates for borrowers with a unilateral ‘floorage’ (at zero) and to charge (when possible) interest on deposits, the situation is not sustainable in the medium term. They have floored all borrowings to ensure minimum margins. But some institutions cannot easily charge negative rates to high income earners. All-in negative rates are weakening banks, insurance companies and pension funds. The guaranteed minimum rates, imposed by the EU Member States, penalise them, forcing them to seek returns and yields in alternative funds, real estate or private equity to offset the shortfall, which is almost impossible in the medium term. Private Equity (PE) funds are seeing their Internal Rate of Return (IRR) reduced and it is difficult to find new investments and targets at attractive prices, without high multiples. Many funds have shifted to PEs to compensate for low rates in prime currencies. Even cash pools are affected by negative rates on transfer pricing. It is difficult to justify real rates applied while remaining at arm’s length.

The Swedes managed it!

Sveriges Riksbank, the Swedish central bank, some months ago decided to end a period of negative interest rates, and increased its rates by 0.25 percentage points, from -0.25% to an annual rate of 0%. The ten-year bond rate went from -0.40% to +0.08%, which means a long commitment just to recuperate your principal – very disappointing in terms of return. But the fundamental question is whether the other central banks, including the European Central Bank (ECB), will follow the Swedish example? Are there really any advantages to retaining negative interest rates?

A return to zero percent in the Eurozone would change everything. Banks are already suffering from this persistent negative climate and going lower would be even worse; it wouldn’t change anything but might even sink already damaged stakeholders (e.g. banks and insurance companies). It is still not clear what the advantages of the last five years of negative interest rates have been to the Swedish economy.

The Swedish gesture may seem surprising while their economy is still suffering. Their economy slowed down badly in 2019. So why did they make this move against the tide? Business confidence is low, industry remains weak, trade tensions look strong, the outlook is bleak, and inflation is limited to 2%, which seems quite reasonable. Savings of private individuals (via retail banking) have been impacted, the financial sector has seen its profitability plummet, at the risk of destabilising the whole sector. Mortgage loans are exploding (as they have become so cheap), creating possible financial and real estate bubbles and high household debt.

In my opinion, the negative elements caused by rates below 0% have largely supplanted the positive elements. Perhaps the solution really does lie in a return to a zero rate.

No more sub-prime crisis

We don’t want another sub-prime crisis (although we are now suffering a health crisis which is possibly even worse). Maybe the Covid-19 consequences are not conducive to raising EUR rates back to zero at the moment. However, it would be nice to think that the Swedes might inspire the ECB and its new president, Christine Lagarde, to follow suit in the coming months. The Swedish central bank was not the first to enter negative interest rate territory, but it has been the first to return to zero percent. This may prove to have been a wise decision. Personally, I think EU Member States could still benefit from improved debt service, while the banks could avoid the harsh decision to tax current accounts.

Zero rates would allow the best of both worlds and would also avoid having to explain to the general public and retail customers that their savings will be penalised at a negative rate and that they will lose money over time. I hope that the ECB will watch Swedish developments closely and draw inspiration from them soon, before the damage to financial institutions, insurance companies and pension funds is too great. These three sectors are suffering from persistent negative rates, and if it continues this could have dire consequences for them especially with the added problems of the current health crisis.

Why less than zero is not beneficial

Too low rates and potentially near-zero mortgage credit could be compared to purchases during Black Friday sales. You shouldn’t buy a house just because it’s cheap, but because you want to live in it. The economy should be re-calibrated, and the target set back to zero. Negative rates unquestionably create a real estate bubble. Companies in difficulty, the so-called ‘zombie’ companies, survive with loans that are too cheap. Private banks are drained and made desperate by deposit rates they cannot charge their rich customers. Pension funds and other insurance companies suffer as they need to ensure minimum returns.

Households and Member States have become over-indebted (even though the debt service charges are easier). Investors are flocking to hedge funds, alternative funds and other instruments in search of better returns. Furthermore, the lower cost of debt makes us forget the increase in total debt. Negative rates impact discount rates, potentially including weighted average cost of capital (WACC), and can inflate discounted cash flow (DCF) valuations. And there are many other reasons not to stay at sub-zero rates. If they persist, this will be detrimental to the entire economy and the banks. The consequences of this rates madness and the inversion of any financial theory will only become apparent later, and the awakening will be painful.

It is not normal to be paid to hold other people’s money, especially if you are not a bank with impregnable coffers. It would be ridiculous to see individuals keeping fiat money (i.e., bank notes) in chests or boxes under the bed just to have zero return because it is better than -0.60%. Let’s never forget that ‘performance is relative, even below zero percent’.

Time is a killer

There are many more unfortunate consequences of such depressed EUR rates. Worst of all would be the destabilisation of the whole banking system. The banks are already suffering heavily from persistent negative rates. I can’t be certain that these rates will not eventually have an effect more perverse than it seems now, more haunting, more devious and misleading.

Future economic textbooks will explain to our grandchildren that more than the global financial crisis or the regulations that followed it, it was negative rates that destabilised the financial edifice and shattered economic principles. No, these negative rates are not always positive and I personally see more cons than pros. They will force us to reconsider our fundamental and founding principles to adapt to a situation that is, to say the least, abnormal. Time is a killer is the title of a novel by Michel Bussi, and this is certainly true in terms of interest rates. Time used to generate value…time was money…but today, time no longer creates value, it destroys it.