Negative interest rates

Negative interest rates

Photo by Jonas Verstuyft on Unsplash

If you’ve got savings with National Savings and Investment (NS&I) you should already be aware that they’ve significantly reduced their interest rates.  This continues a trend that has been ongoing since 2008.  For example, NS&I income bonds paid 4.7%pa in 2008; the rate had dropped to 1.75%pa by 2013 and is now just 0.01%pa. This is a trend that isn’t exclusive to NS&I.

Today, government bond yields and all bank deposit rates sit very substantially below where they were 5 and 10 years ago, in negative after-inflation terms and more-or-less-zero before inflation terms.  In March this year, the UK Government issued its first negative-yielding gilt when it borrowed £3.8 billion at 0.003% for a 3-year maturity.  In other words, they’re getting paid to borrow money by investors!  What a strange world we’re living in.

The Bank of England (BoE), alongside other central banks, has hinted that negative interest rates remain in its arsenal of tools to help the economy.  Denmark has already seen home loan offers at a negative interest rate, meaning that mortgage borrowers pay back less than they borrow!  One can perhaps see why the BoE sees this as a useful stimulant in helping firms and consumers to have the confidence to borrow.  However, if commercial banks are charged for placing deposits with the BoE then, in all likelihood, they will pass these costs onto retail depositors.

In effect, negative interest rates represent a transfer from savers to borrowers.  However, there would appear to be limitations to negative rates as banks and individuals might well decide to hold physical banknotes instead at no cost (excluding secure storage costs) if negative interest rates persist. 

One possible solution is to run a system of dual interest rates[1].  Specifically, this could be targeted at one rate for bank lending (e.g. -1%) and one for bank deposits (e.g. +0.5%).  Various terms and conditions could be applied, such as directing the type of lending the banks could do with this facility.  It’s even been suggested that this could be used to drive a new ‘green deal’, whereby money would be available to companies focused on sustainability considerations.  Borrowers’ disposable income would rise, as would the benefits of greater economic stimulus through lending to companies to invest in projects.  At the very least, this is an interesting concept. 

Negative interest rates for deposits, if implemented, would result in no interest on saving accounts, so not really very different to what we’re receiving now, especially after inflation. 

However, you might be concerned with how this could affect your other longer term investments.

If the BoE interest rate turned negative it could boost equity markets, as savers and investors are incentivised to take on more risk by pursuing the higher expected returns associated with equities.  We’ve already seen this in the last few years with low interest rates benefiting some companies and stimulating the economy.  This has particularly had a positive effect on ‘growth’ companies and if sterling falls against other currencies, it could also benefit larger international companies who sell their products and services overseas. 

You’d think that the share price of banks would suffer if negative interest rates were introduced because this would result in another cost, thereby reducing future profits.  However, as I’ve said before, the market, being an aggregate of lots of views and information, is likely to have already accommodated these factors into most companies’ share prices.  So, like any other time, this isn’t the time to be trying to pick individual companies or sectors that might do well or better if negative interest rates are introduced.  With a properly diversified portfolio you should be able to benefit from any positive effects on equities and minimise any negatively affected sectors.

Defensive assets, such as fixed interest securities (bonds) should see their prices rise and yields fall as interest rates become negative.  However, some short-dated bonds already have negative yields so the increase in their prices should be minor if there is only a small lowering of interest rates.  Bonds with longer terms to maturity are more sensitive to interest rate changes and therefore are likely to see larger price movements.  One of the reasons why we hold short-dated bonds in the defensive allocation of our portfolios is to minimise the impact of interest rate movements.

Negative interest rates might lead to higher inflation, so holding index-linked bonds would provide some protection from this, but it’s hard to know when and what exact effect on inflation this would have.  We include an allocation to index-linked bonds in our portfolios to provide some inflation protection irrespective of interest rates.

You might also consider gold being the answer as its price is likely to continue its recent upwards trajectory if negative rates are introduced.  However, as I’ve said before, investors in gold need to be aware that its price can move quickly and one of hardest decisions is knowing when to sell before everyone else does.  Good luck with that! 

Rather than try and second guess where to be invested if and to what extent negative interest rates are introduced. It will be more productive to ensure you have a diversified portfolio that you maintain the appropriate risk allocation for you by using a disciplined method of rebalancing.  Then all you need to do is stay invested, rebalance, retain cash savings that you’re comfortable with and that you need for short term expenditure and wait for interest rates to move back into positive territory.  

The one thing that is certain is that it will be extremely hard to preserve the purchasing power of cash in the coming months, and possibly years, even if there are no further reductions in interest rates.  However, having enough cash to meet emergency liquidity needs is still important.  Make sure that any longer term investments are adequately diversified and try not to second guess the market as the future will always be unknown.

Cheers

Charles

[1]              Eric Lonergan, Megan Greene, 03 September 2020, Dual interest rates give central banks limitless fire power. https://voxeu.org/