OpinionFeb 25 2016

Mind the rates gap

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At the end of January, the Bank of Japan introduced negative deposit rates with a tiered programme. In December 2015, the European Central Bank cut its deposit rate by 0.1 per cent to -0.3 per cent. Let us not forget the two banks that were the first at this party: Denmark and Switzerland, which implemented negative deposit rates in 2012 and 2015, respectively. In the past year, we have seen short- and medium-term bond yields trade lower and lower into negative territory across the Eurozone and Scandinavia, throwing into question the very essence of a fixed income security: that the borrower should be paying the investor interest, not the other way round.

Slowing global growth and weakness in emerging economies have dragged on developed market growth projections. Inflation expectations for most developed economies have been low and continued to drop even lower over the past few quarters. The goal of low interest rates is to introduce more money into an economy and incentivise banks to lend to companies and consumers who will then spend. Cheap money encourages spending, increasing demand for goods and services.

Banks hold capital reserves at the central bank, either to meet regulatory requirements or settle transactions. Innovations by the ECB and, most recently, BoJ have enabled them to push policy rates well below zero, but segmentation among the reserves means that not all assets are being charged negative interest rates. Certain required reserves are held with positive interest rates, but any excesses will be “charged,” which means central banks are closer to achieving their goal: to push money into the economy while not hurting the profitability of financial companies that still need to hold some capital at the central bank. The reserves subject to negative interest rates represent only a very small share of total assets in these economies. In Japan, a negative interest rate is applied to only 0.9 per cent of total bank assets. In the euro area it is applied to 2.2 per cent; in Sweden it is 2.4 per cent; in Denmark it is 3.1 per cent; and in Switzerland it is 3.5 per cent.

As such, negative policy rates have worked broadly, as the central banks had hoped in Europe: banks have not started to stockpile physical cash to avoid a negative interest charge. Japan and Switzerland have even crafted penalties for banks who stash cash in this negative rate environment.

Central banks seem willing, to varying degrees, to go even lower than they already have. While short-dated government bond yields have come down to very low levels, this does not mean consumers in these economies are shelling out money to keep their savings at the bank – yet. Currently, the pass-through to the customer on the street is low. Household deposit rates should remain around zero, but corporate deposit rates are more likely to move into negative territory, as has already happened in Denmark. As the consumer in these economies is not yet affected by negative rates, there is little in the monetary policy realm that should derail the strong, developed market consumer story.

When money is cheaper to obtain and costlier to hold for institutions, capital market asset prices rise. Ultra-supportive central bank asset purchase programmes have supported the sovereign bond rally a good deal already, but expectations of further action mean some bonds, for example, peripheral eurozone (Spanish, Italian and Irish) bonds could catch up with their core (French and German) counterparts. Equity markets in negative rate regions, particularly the eurozone, should benefit from the economic growth that loose monetary policy supports. More money in the eurozone economy (M1) has a close relationship to gross domestic product growth in the region. Given the 2016 sell off, eurozone equities are near pre-ECB quantitative easing levels, which means there is some value to be found in companies with solid fundamentals.

There is still more to come in the world of negative interest rates. Since a small portion of total assets are actually charged these rates at the moment, central banks who want to go even lower have some scope to do so. As investors, we need to monitor if and when the negative interest rate will start affecting corporate profitability and consumer savings accounts. Until then, supportive central banks should be a tailwind to these economies.

Nandini Ramakrishnan is global market strategist at JP Morgan Asset Management