Negative yields are becoming the new normal

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).

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.

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.

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.

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.

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.

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.

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.

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.