While financial market observers in the US remain focused on the timing and magnitude of the Fed raising target interest rates over the months ahead, European bond markets have begun to experience just the opposite - the never-before-seen phenomenon of actual negative bond market interest rates. Since the Global Crisis of 2008, which saw both the Fed and foreign central bankers seeking both to calm markets and to encourage growth by reducing rates to the 'zero bound,' interest rates for bellwether German bonds and across Europe in late 2014 crossed into negative territory, and for the first time in world history. As noted recently by iconic market veteran Art Cashin, now Director of NYSE Floor Operations for UBS Financial Services, over 30% (approximately $2.2 Trillion) of the highest-rated sovereign debt in Europe now bears a stated negative interest rate. Over 70% of all German government bonds now carry negative stated rates, and there are indications these conditions may become even more wide-ranging and spill over to US markets. After more than six years of various central bank 'Quantitative Easing' (QE) stimulus programs including scheduled open-market bond purchases, negative interest rates now clearly constitute the 'new frontier' of central bank monetary policy. Numerous other policy implications regarding negative rates are still unfolding in an uncharted scenario, which even the founder of modern monetary theory, John Maynard Keynes, did not foresee.
In an environment of ultra-low and negative rates, non-interest-bearing asset classes including commodities should become more attractive. Therefore, one major historical disincentive to buying oil and gold, for example, may have been removed. Stated differently, increasingly negative interest rates should be positive for commodities, because the imbedded math suggests that an investor is effectively paid to hold them, as compared to holding negative-rate financial instruments.
On the surface, negative interest rates represent a confusing and counter-intuitive 'new math' which can be difficult to grasp. Stated plainly, at least $2.2 Trillion of European bond investors are now paying for the guaranteed right actually to lose principal, and to receive back less than they have invested. This highly unusual scene seems to tell us that at least some sophisticated institutions are perhaps embracing the loss of some principal by investing with various sovereign governments, rather than face the loss of even more principal by making other types of investments. Viewed from a slightly different but equally important commercial bank perspective, negative rate monetary policy also seems very plainly to encourage far more aggressive commercial bank lending activity. Negative rates may serve to penalize banks which do not lend, or at least which do not lend to businesses in sufficient volumes to promote desired growth.
Bank lending to businesses has long been regarded as the grease of the wheels of commerce and growth since the days of Adam Smith. Unfortunately, for today's central bank growth advocates, many commercial banks have been more reluctant to lend into the slowing-growth economies of the US and Europe, where lending activity has been essentially flat over much of the past five years, as compared to the higher-growth economies of the BRICS and other countries. Risk-averse banks have, in a way, preferred to lend their surplus funds to low-risk governments rather than to higher-risk businesses, yet now they may be penalized and urged to shift out of the lower-risk status quo. By adding a mathematical penalty to banks in the form of negative interest rates, the new paradigm thus has added implications which appear to run directly opposite to the risk-averse Basel I-III bank capitalization and risk guidelines which were introduced in 1985. The Basel Accords now carry the effective weight of core bank regulatory guidelines around the world. They are already well known and widely followed by and among the FDIC and metropolitan banks, as well as by virtually all community banks across the US. Changing the risk focus of central bank lending guidelines which have been built steadily and by global consensus over the past thirty years is certainly no small thing to consider.
Eurofi, a European-based think tank chaired by former IMF Director Jacques de Larosiere which carries the support of ECB President Mario Draghi, has the stated goal of 'fostering growth in a highly indebted EU environment.' In remarks prepared for the April 23-25 Eurofi High-Level Seminar and delivered on behalf of the Basel-based Bank for International Settlements (often known as the central banks' central bank), 20-year BIS veteran and Deputy General Manager Herve Hannoun recently addressed the growing phenomenon of negative interest rates among a 'Who's Who' of central bankers, international banks, insurance companies, financial market makers, rating agencies and regulators. Eurofi's many activities have included the pursuit of a possible new Capital Markets Union (CMU) under the recent leadership of Lord Hill of London. Among its initiatives, Eurofi is addressing the technological and regulatory framework for new growth-oriented lending and capital market mechanisms across Europe. Given the recent emergence of crowd-funding, P2P (Peer-to-Peer) financial activities, and promising new technology and delivery platforms, one possibility before Eurofi is to reconsider the traditional role of how commercial banks have functioned as intermediaries between depositors and business borrowers. With negative rates, the linkage between expanded business lending activity, increased monetary velocity and broad economic growth now appears clearly to be a higher priority for European central banks and regulators.
As the BIS' Hannoun noted in his published remarks, "An experiment is under way in continental Europe to test the 'boundaries of the unthinkable' in monetary policy...The main aim of an ultra-low interest rate policy is to deter saving and encourage borrowing." Interested US-based banks and institutions were amply represented at the Eurofi Seminar, and they will no doubt give due consideration to growth mandates and possible banking developments on this side of the Atlantic as well. As noted, the full implications of negative rates are still unfolding. For the present, one result may be that banks do more than ever before to enhance economic growth. Institutions, private investors and those interested in alternative investments around the world will be following this story, and to assess where to invest. As NYT best-selling economist and author Jim Rickards has recently noted, "in a world of negative interest rates, gold (becomes) a 'high yield' asset." An environment of negative interest rates, if it continues, seems likely to produce other emerging issues.
Douglas E. Johnston, Jr., is a C-Level executive with national experience in the core development of five 'best in class' companies in five different industries including Mergers & Acquisitions, Commercial Banking, Nationwide Commercial Real Estate, Consumer Products Manufacturing, and Media / Entertainment.
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