Where There’s Smoke: The Risk of a Negative Rate Reality

June 9, 2020

5 minute read

by David Stonehouse, AGF Management Ltd.

Sometimes financial markets just won’t take “no” for an answer. Central bank officials in the United States, Canada and the U.K., along with other developed countries, have long been adamant that they are not likely to follow their counterparts in Europe and Japan by adopting negative interest rates. Of course, they never explicitly say they won’t ever, but their discomfort is apparent. The latest denial came in mid-May from U.S. Federal Reserve Chair Jerome Powell. “The [Federal Open Market Committee’s] view on negative rates has not changed,” he said. “This is not something we’re looking at.”

That sounds pretty declarative. And yet, over the past few weeks, there has been an increasing volume of chatter about whether more central banks should go down the neg-rate rabbit hole, driven by comments from some bank-watchers, economists and fund managers whose musings range from acknowledging the possibility to outright recommending it. Faced with a dismal economic growth outlook, financial markets have even started to price in the prospect. In May, rate probabilities turned slightly (and briefly) negative on U.S. Fed Funds Futures for mid-2021; they are still flashing red for rates in the U.K., whose Debt Management Office recently issued the first negative-yielding bonds (three-year gilts, with a 0.003% yield) in its history.

So, are these bastions of traditional (i.e. positive) interest rates really beginning to crumble? Not really. Yet it might still behoove investors to consider the possibility.

Let’s be clear: negative rates are not the preferred tool of U.S., Canadian and U.K. central banks for further stimulus. Before they go down that road, they are more likely to expand quantitative easing programs and funding facilities – as the Fed has already done – or to introduce yield curve controls like the Bank of Japan did several years ago. These are by no means “conventional” policy measures, but they are likely far less distortive to the healthy functioning of western economies than negative rates would be.

Why? For one thing, negative rates could put even more strain on the financial system by crimping bank profits, by magnifying the liability profile of insurers and pension funds, and by severely damaging money markets – which are far more important to short-term bank funding in the U.S. than in Europe. As well, negative rates haven’t been very successful in stimulating economic activity in Europe and Japan; some jurisdictions, such as Sweden and Denmark, have actually reduced or removed them altogether. And on top of those practical and empirical issues, there is an overarching philosophical one: negative rates just seem antithetical to capitalism. In our system, you are supposed to pay to borrow and make money from taking on the risk of lending – not the other way around.

Still, despite all those concerns, what if central bankers like Powell are just protesting too much? When pushed, most do concede that negative rates remain a tool in their policy kit – just not “for now.” Yet they might not be able to put off consideration of negative rates if financial markets start pricing in a stronger likelihood; central banks have often followed where markets have led, and have not always been able to resist market pressure (despite trying). In the U.S., at least, there is also political pressure. President Donald Trump has long advocated for negative rates, arguing that the U.S. has the best debt in the world and therefore should make it the most expensive. And on the economic front, one could argue that negative rates are necessary, perhaps even inevitable, in the current crisis. Central bank rates have typically fallen by four to five percentage points in a recession, so from a starting point of 2.5% in the U.S. and 1.75% in Canada, rates could easily head into the red.

If they do, we can envision some potential benefits in the short term. Negative rates could spur consumption and investment during the COVID-19 crisis. Depending on how widely different countries adopt them, they could also weaken currencies, boosting exports. They would almost certainly lower funding costs and alleviate solvency concerns, not just for individuals and businesses but also for governments, which have to pay for all those emergency measures somehow. (They might also help some avoid default – for example, the state of Illinois, whose bonds had been approaching junk status even before the crisis.) These “benefits” might also come with some populist appeal, which could be pertinent during a U.S. election year: with negative rates, Wall Street pays and Main Street gains.

By no means are we advocating for negative rates; in many respects, they are distasteful and we would not be proponents. Yet it’s important to acknowledge the possibility of negative rates, however unlikely. Investors should not dismiss it just because they think it’s a bad idea. In such a situation, potential winners could include bonds (in anticipation of even lower yields), or gold (as a wealth preserver and beneficiary of negative yields), or growth stocks and other rate-sensitive assets. Those categories generally performed well during the recent downturn, although they have started to lag as markets begin to price in a recovery. Indeed, even when it comes to something as once-unthinkable as negative rates, it’s best to be prepared and consider the investment ramifications.

After all, where there’s smoke, there could be fire.

David Stonehouse, Senior Vice-President and Head of North American and Specialty Investments, AGF Investments Inc. is a regular contributor to AGF Perspectives.

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