Negative asset prices have crept their way into the world of investing over the last decade. In 2009, the Swedish Riksbank lowered one of its key interest rates into negative territory, the first major central bank to do so.
With negative interest rates now the norm in Europe and a particular oil contract even settling below zero – investors are having to navigate them as part of their investment strategies.
Here in the UK, recent chatter around negative interest rates from the Bank of England has risen. Andy Haldane, the BoE’s Chief Economist, has stated that he’s very interested in negative interest rates as a tool to help boost the economy. We thought this would be a good opportunity to look into them further.
Why would negative rates be used?
Lower interest rates have long been used to try and stimulate an economy.There are numerous theories as to why this would work. Some economists say it makes it less attractive for investors to allocate funds to cash (taxing their savings if you’re being less charitable) will force them to find a home for their assets further out on the “risk curve”, or that it makes money itself cheaper – and therefore more of it will be spent
From the perspective of an investor, this forces them to take funds out of cash and put it into bonds/stocks, therefore providing capital to people, companies, or governments at a lower cost than they otherwise would have. These entities can then spend more, theoretically helping perk up an otherwise lacklustre economy.
Will dropping benchmark interest rates below zero aid this further? The jury is still out. Mainland Europe, Scandinavia and Japan (where negative rates are already in place) haven’t seen economic booms. However, the situation could have been worse without this policy, and it’s often very difficult to prove the effectiveness of a particular tool when judging something like an economy that has so many moving parts.
A mixed picture
The primary aim of lowering interest rates is to stimulate the economy, so let’s look at economic growth plotted against interest rates in the US, EU and Japan;
The results aren’t particularly clear cut. Cutting interest rates has been followed by periods of stronger economic growth – but correlation certainly does not equal causation in situations like this.
However, you cannot invest in GDP, so let’s change the charts to show the regional stock market performance.
As you can see below, US interest rates and US stock prices are negatively correlated (as interest rates have fallen, stocks have risen) – to an extent. Shift our focus to other geographies, however, and the picture becomes less clear cut.
Both European and Japanese bourses saw some positive performance when rates dropped below zero (in the aftermath of the financial crisis). But, each geography had its own issues. Europe jumped from the financial crisis into a more localised regional debt crisis (the Greek government had to pay investors nearly 40% to borrow money for 10 years). Japan has long been fighting an ageing and shrinking population.
It can be argued that negative interest rates were a symptom of these issues, rather than a cause of any slight pickup in either the economy or the stock market.
Now, a necessary statistical point. It is easy to argue that any link between equity markets and interest rates can be described as ‘spurious correlation’. This just means two variables are correlated (positively or negatively), but there is no causation – one has nothing in common with the other. It is very difficult to prove the relationship between interest rates and stock market indices, but the economic theory would suggest there is some relationship. It is also key to remember that other monetary (central bank) and fiscal (government) policies have been used during this period, which also influence both the economy and the stock market.
However, one can still take conclusions from this data, even if the evidence is not crystal clear. Interest rates are going to stay low for the foreseeable future – central bankers have made this clear. Stocks, whilst not predicted to set the world alight as they have for most of the past decade, still have a positive expected return.
What happens when rates drop below 0?
This, like any policy, benefits some more than others. About to take out a loan? Great, it’s going to cost you far less. Have any money in a savings account? Not ideal.
In practical terms, banks depositing money with their respective central bank are charged interest for doing so, rather than receiving interest. Policy makers hope this is passed on to the banks’ clients in the form of lower or negative rates. In a world of low, but positive inflation, this can really begin to hurt savers. When the ‘real rate’ (the rate of return adjusted for inflation) drops below zero – as it already is in many developed economies – your cash savings actually lose value over time.
Whilst we’ve primarily focused on the economic theory, what it means in practical terms is a low or even negative rate of interest for savers. This makes it much more difficult for people to reach their financial goals by using cash savings accounts.
Embracing the policy
If policy makers want investors to allocate more to risky assets, is this suitable for ordinary investors? If you’re investing for the long-term, then we think it is. We believe a portfolio made up of stocks, bonds and commodities has the power to grow your savings faster than the rate at which inflation eats away at them, as it has done historically.
Cash accounts, whatever the interest rate, will always have value. The shorter your timeframe for saving, the more the certainty of cash outweighs the potential of returns with risky assets.
However, when investing for a few years or more (especially for retirement, which could be several decades away), portfolios of stocks and bonds come into their own. If interest rates stay low, or even drop below zero, then a portfolio of investments could be one of the only ways to effectively save for your future.