The Bank of England made a U-turn last week, acknowledging that it was considering following Europe and Japan down the path of negative interest rates. On the same day the UK government issued 3-year gilts at a rate of -0.003%.   So are negative rates the solution to the economic fallout of the COVID crisis or will they just make things worse?

As long as other countries are receiving the benefits of Negative Rates, the USA should also accept the “GIFT”. Big numbers!

Donald Trump, US President, May 2020 (via Twitter)

Of course, we’re keeping (negative rates) under active review in the current situation…we do not rule things out as a matter of principle.

Andrew Bailey, Governor, Bank of England, May 2020

In the aftermath of the Global Financial Crisis 2008, the Bank of England (BoE) decided that 0.5% was the ‘lower bound’ of interest rates.  After the Brexit vote in 2016, this limit was lowered to  ‘close to, but a little above, zero’.  In other words, interest rates could get really low, but the idea of paying borrowers to borrow was not on the cards. 

As recently as last week, BoE Governor Bailey was keen to reaffirm this position, saying that he was not ‘planning or contemplating’ introducing negative rates as a remedy for the current economic shock.  This position was in line with the US Federal Reserve, where Fed Chair Jerome Powell has been vehement in his opposition to negative rates, despite the Twitter exhortations of a President consumed by the machinations of monetary policy and the stock market.

But the Bank of England is desperate, as is President Trump who faces re-election at a time when the US unemployment rate has jumped to its highest level since the Great Depression. Desperate times call for desperate measures, and negative rates are certainly a desperate measure.  Based on the experiences of Europe and Japan, the most compelling argument for negative rates seems to be based on the counterfactual.  Things might have been even worse without them (in Japan and Europe), but a path to economic nirvana they most certainly are not. 

The theoretical case for negative rates is easy enough to make.  A lower interest rates means looser monetary policy and more demand for credit, leading to economic expansion.  As zero is simply another number, there is no difference between cutting rates from 3% to 2%, for example, and cutting them from 0% to -1%.   Add to this a depressive effect on the currency and a boost to asset prices (presumably why Mr Trump is such a fan) and voila! – COVID crisis solved, at least in an economic sense.

As is often the case, the reality is not so straightforward.  Japan was the first country to embark on the journey of ultra-low  (eventually negative) rates, bringing interest rates to zero back in the late 1990s.  It is also worth noting that at that time, six of the largest ten banks in the world were Japanese (including four of the top five).  Now, there is only one (Mitsubishi) in the top ten, and Japan has experienced a ‘lost 20 years’ of economic stagnation, the highest levels of public debt (debt to GDP approaching 250%), and the lowest levels of productivity growth of any developed nation.   

As it turns out, the bank vitality and economic strength are actually pretty interconnected.  And negative rates are really bad for banks.  European banks have struggled since negative rates were introduced (Chart I). During this period European debt levels have crept up, and economic growth has been sluggish.  Banks are a critical source of credit creation in developed economies and damaging them has a direct adverse effect on a country’s economic potential.

Chart I: European bank stocks have declined by 75% since 2010
Chart II: US bank stocks have risen by 50% since 2010

Correlation does not mean causation of course, but it is interesting to compare this to the performance of US banks, where interest rates (until recently) were normalizing (Chart II).  And the US economy has been relatively vibrant, at least until the onset of the COVID crisis.

One theory as to why negative (or even just ultra low) interest rates are counterproductive is the postulated existence of a Reversal Interest Rate (RIR).  According to a recent study by Princeton University, the RIR is the rate at which accommodative policy becomes contractionary.  In other words, it is the rate beyond which further interest rate cuts actually have the opposite effect to that which is intended.

According to the theory, there are a number of idiosyncratic factors that determine the RIR, including:

  • The fixed income holdings of banks – the more bonds the banks have, the more they will benefit from rate cuts (RIR is lower).
  • Equity capitalization – well-capitalized banks can handle the hit to profitability caused by lower rates (RIR is lower).

In other words, the efficacy of negative rates is likely to be to particularly low at the moment because the RIR will be higher.  Quantitative easing has removed a lot of the fixed income holdings from bank balance sheets (meaning they will not benefit directly from rate cuts).  Similarly, weakened equity capitalization (caused by writing down loans) means that banks will struggle to endure the lower profitability caused by ultra-low / negative rates.   

If banks are hurt by negative rates, they will lend less, which will have a contractionary effect on the economy.   Even worse, this will create a vicious circle, whereby economic stagnation will further reduce bank profitability, meaning banks will lend less, the economy will shrink further and so on.  This theory seems to be supported by what we have seen in Japan for over two decades, and in Europe for the past decade. 

Negative rates are not the answer to the economic crisis.  If anything, they are likely to make things a lot worse and I would argue (controversially) that raising rates would be a preferable course of action at this time.  That looks very unlikely to happen in any developed economy, and particularly unlikely in Europe (which already has negative rates) or the UK (which is now considering them).  This supports our bullish view on the USD, due to the Fed’s relative reluctance to countenance negative rates, and gives us reason to reconsider our more constructive outlook for GBP.

Author: Kevin Lester