united kingdomen
Negative yields are becoming the new normal

Negative yields are becoming the new normal

06-08-2019 | Insight
The ECB has adopted a long-term negative interest rate policy. Can this work?
  • Martin van Vliet
    Martin
    van Vliet
    Analyst

Speed read

  • Negative policy rates have lowered borrowing costs and given growth an edge
  • Meanwhile, savers are irked, bank profits ease and the search for yield is increasing
  • Expect the ECB to implement “mitigating measures” to reduce negative fallout
We have received a number of queries about negative interest rates and their implications. This report is a compilation of our responses.
Stay informed on our latest insights with monthly mail updates
Stay informed on our latest insights with monthly mail updates
Subscribe

The ECB has adopted a long-term negative interest rate policy. Can this work?

It is very unconventional policy that is much more popular with debtors and borrowers, including governments, than it is with creditors and savers. Clearly, this latter group continues to seek a positive return on their capital.

One of the reasons why negative rates have proven to be a very important tool in the euro area is that this is a relatively open economy for its size, with total trade making up around 50% of GDP (compared with 27% in the US). As ECB president Mario Draghi has explained, this means that the impact of negative rates on financing conditions via the exchange rate has been more powerful. (See also our latest Central Bank Watcher).

Key rates in the euro area

Source: ECB

For fixed income investors, it means that a 10-year EUR bond that yields zero – or even -0.40% – has some value if the alternative – cash or funding cost – is more negative than that. This phenomenon has helped propel European fixed income returns in 2019. We would even go as far as saying that additional rate cuts beyond what is priced in could generate further returns.

It is especially true for high-quality investment grade EUR fixed income such as bonds issued by agencies and investment grade credit.

What is positive about negative interest rate policy? And what problems does it create?

The ECB’s negative interest rate policy (NIRP) has helped bring down market interest rates and bond yields in the euro area. As such, it has helped reduce borrowing costs for many governments, consumers and businesses, with positive effects on economic growth. Note, though, that some bank loan documents have limits at zero, which inhibits the degree to which negative rates can be passed on.

There is a flipside to the policy, though. It has dampened returns on savings, and has put (further) pressure on life insurance companies and defined-benefit pension funds.

Generally speaking, it has also had an adverse impact on banking profitability due to the fact that, while many bank lending rates across the euro area have declined, most bank retail deposit rates have stayed at or (slightly) above 0%, resulting in compression of net interest income for many banks. Admittedly, the ECB has offered banks cheap long-term loans (so-called targeted longer-term refinancing operations or TLTROs) at negative interest rates.

Another, more broader, side effect of the ECB’s NIRP is that it has amplified the search for yield among investors and hence heightened the appetite for risk taking.

Do negative interest rates really create economic recovery?

The policy clearly has had positive and negative effects. According to the ECB it has been positive for the economy, on balance. For example, the ECB has found that the NIRP has induced most affected banks to increase their lending activities. This is also reported by banks themselves in an ECB bank lending survey conducted earlier this year (see the chart below). However, the more negative interest rates become, the closer they get to the so-called “reversal rate”, at which the negative effects on bank profits may lead to a contraction in lending.

Impact of negative ECB deposit facility rate in the six months to April 2019

Source: ECB

What are the main problems of the ECB’s current policy?

The biggest problem with ECB policy is that, despite all the stimulus measures, including asset purchases and negative interest rates, inflation in the euro area has failed to move back in line with the central bank’s medium-term objective of keeping inflation “below but close to 2%”. The implication is that the ECB risks losing its credibility or might have to resort to even more unconventional policy measures. (See also: Credit outlook: Be smart, quick and lucky).

Moreover, removing the disciplining mechanism of market-determined interest rates eliminates the element of creative destruction from the economy, throttling default rates down to artificially low levels and preventing the redeployment of labor and capital in more profitable, forward-looking enterprise. In other words, it might structurally lower growth potential. A side effect of both points is that it should keep fixed income yields contained.

A more structural problem of ECB policy remains that that it is based on macroeconomic conditions in the euro area as a whole and (hence) does not fit the particular circumstances in each of the countries of the region.

What worries you the most about the European economy?

From a cyclical point of view, the sharp slowdown in the manufacturing sector is worrying. The good news is that services-sector activity has held up relatively well in many countries. Moreover, there is the lingering risk of a “hard Brexit” of the UK from the European Union. (See also: The Fed’s sugar rush rally).

Structurally, a key issue for the Eurozone is the trend decline in economic growth in the wake of an aging population. Moreover, the rise in populist nationalism across the region poses a risk to the solidity of the Economic and Monetary Union.

Do you think that the tiered interest rate plan used by Japan, Denmark, and Switzerland can become the future direction of ECB monetary policy?

The ECB has recently hinted at a possible further reduction in its key policy rate, the deposit facility rate, further into negative territory (it was at -0.40% as of 24 July). And although it still sees the net effect of negative rates on the Eurozone economy as positive, it has suggested that “mitigating measures” to contain any negative side effects on the banking sector are part of their toolkit. This has fueled expectations that the ECB could indeed soon move to a sort of tiered deposit system as implemented in Japan, Denmark and Switzerland, where banks are not charged the negative interest rate on all of their excess reserves at the ECB (they are charged on a portion only). We believe that it is indeed more likely than not that, if the ECB implements a further rate cut, as we expect, mitigating measures will be applied.

Subjects related to this article are:
Logo

Disclaimer

Please read this important information before proceeding further. It contains legal and regulatory notices relevant to the information contained on this website.

The information contained in the Website is NOT FOR RETAIL CLIENTS - The information contained in the Website is solely intended for professional investors, defined as investors which (1) qualify as professional clients within the meaning of the Markets in Financial Instruments Directive (MiFID), (2) have requested to be treated as professional clients within the meaning of the MiFID or (3) are authorized to receive such information under any other applicable laws. The value of the investments may fluctuate. Past performance is no guarantee of future results. Investors may not get back the amount originally invested. Neither Robeco Institutional Asset Management B.V. nor any of its affiliates guarantees the performance or the future returns of any investments. If the currency in which the past performance is displayed differs from the currency of the country in which you reside, then you should be aware that due to exchange rate fluctuations the performance shown may increase or decrease if converted into your local currency.

In the UK, Robeco Institutional Asset Management B.V. (“ROBECO”) only markets its funds to institutional clients and professional investors. Private investors seeking information about ROBECO should visit our corporate website www.robeco.com or contact their financial adviser. ROBECO will not be liable for any damages or losses suffered by private investors accessing these areas.

In the UK, ROBECO Funds has marketing approval for the funds listed on this website, all of which are UCITS funds. ROBECO is authorized by the AFM and subject to limited regulation by the Financial Conduct Authority. Details about the extent of our regulation by the Financial Conduct Authority are available from us on request.

Many of the protections provided by the United Kingdom regulatory framework may not apply to investments in ROBECO Funds, including access to the Financial Services Compensation Scheme and the Financial Ombudsman Service. No representation, warranty or undertaking is given as to the accuracy or completeness of the information on this website.

If you are not an institutional client or professional investor you should therefore not proceed. By proceeding please note that we will be treating you as a professional client for regulatory purposes and you agree to be bound by our terms and conditions.

If you do not accept these terms and conditions, as well as the terms of use of the website, please do not continue to use or access any pages on this website.

I Disagree