The Great Negative Rate Debate

by J. Kevin Meaders, J.D., CFP®, ChFC, CLU May, 2016

With all the news media focused on the election circus, very little time is dedicated to the anomaly that has now exposed itself upon foreign shores: negative interest rates.

You read that right. Negative interest rates. Just when you thought the world couldn't get any weirder, it has.

So let's take a look at this strange phenomenon and explore what negative rates are, why they're happening and what they might mean to us as consumers and as investors.

To rejuvenate a stalled economy, central banks have two weapons in their arsenal-printing money and lowering interest rates. The intended consequence being that the banks will have money to lend to consumers at low interest rates, encouraging spending, thus circulating money into the economy.

However, if the money is printed and the banks sit on it, earning interest for themselves, then the plan is forfeit. What to do?

When the carrot doesn't work, it's time to bring out the stick. Enter negative interest rates-if the banks have to pay to keep their money with the central bank, then maybe they'll lend it out to consumers, starting the desired cycle. [1]

Here you can see the Swiss banks going negative at the end of 2014 to -.8%. Of course, at the time, none of this made headline news because Switzerland doesn't impact the world economy too terribly much. But since then, other desperate economies have started to use the stratagem—large enough economies to shake the world markets.

The European banks went negative in the middle of last year, to about -.25%. And not to be isolated to the European theater, the Japanese have imported negative rates to the Land of the Rising Sun. Here you can see Japan's rate going negative in the first quarter of this year, down to just a fraction of a percent negative.

So now, out of the world's four largest economies, the European Union, the U.S., China, and Japan, two of them  employ negative rates-Japan and the E.U. In all, there are currently nine countries employing negative rates. [2] You know there is something very wrong with an economy when interest rates go negative. Can't you just intuitively feel that?

The reason given by the European Central Bank for negative interest rates is "to further ease the already accommodative monetary policy stance to fight the growing threat of deflation amid downward pressures to inflation expectations."[3]

In short, they want more inflation. The lesson-like most economic lessons (as my econ professor Dr. Shropshire drilled into my psyche)-goes back to simple supply and demand.

Inflation comes from an increase in the money supply. The more money out in the economy, the less each unit of money is worth in terms of what you can buy. This is bad news for consumers like me and you-we see it when we visit our local grocery store.

So who benefits from high inflation? Highly indebted countries (and people). In fact, for debtors, the more inflation the better. Inflating money helps to drive down the real costs of debt.

For example, a $1000 debt in 1920 was huge; today its peanuts.  And this is significant to a country sitting on $19 trillion in debt, like us for instance.

We've explained that in utilizing negative rates, the central banks are trying to force people out of cash. They don't want the banks sitting on it and they don't want consumers sitting on it either. They want you to spend it, which helps stock prices. And they want you to invest it, which also drives up stock prices. But most of all they want you to borrow it, because in a fractional-reserve banking system such as ours-borrowing actually "creates" money, and remember more money means inflation.

So is it working? We are finding that no matter how much money they print, no matter how low they drop rates (zero used to be considered the bottom), no matter how low they set the bank reserves ratio, people are just not borrowing.

Just because you have a lot of something doesn't mean people will want it. And yes people always want money, but what we have seen is that they just don't want the associated debt. Even if it's 'cheap' debt.

So what does all this mean to us as investors? That's the million dollar question. Already, we have seen where investors have begun to withdraw their cash rather than pay the negative interest. This has induced some lawmakers in Europe to consider getting rid of cash money altogether.

In early 2015, JPMorgan Chase forbade some customers from storing cash in safe deposit boxes. Swiss banks refused to allow pension funds to withdraw large amounts of cash from their accounts. Danish legislators proposed a law allowing shops to refuse to accept cash payments. Australia imposed a 0.05% tax on some bank deposits. And France cut the legal limit on cash payments from 3,000 Euros to 1,000 Euros. [4]

I foresee a day when cash as we know it will cease to exist. Everything you buy will be through electronic means, and every transaction open to government scrutiny.

Whatever the consequences with the negative interest rate experiment, we just don't believe it can be good in the long run. This completely undermines savers, and forces

conservative investors into alternative products that carry too much risk.

If nothing else, we now know that zero is not the bottom, so the Fed is watching Europe and now Japan with great interest. Perhaps they think they have found another arrow in their quiver, to use when the market takes another 2008-style dive. I think you can bet on it.

So with low interest rates, quantitative easing (money printing), and now negative rates, one would expect global stock markets to soar, but this has yet to occur.

What are we to make of this? History has shown that stimulus takes time. It could also be the law of diminishing returns.  We've had so much global stimulus since 2008, perhaps more is just an exercise in futility. Indeed, with all the quantitative easing and interest rate manipulation, we should see price bubbles everywhere.

We look around for massive stock bubbles that might burst, and don't really find any. We continue to believe that stocks are not yet set for a major correction, and that we really need a new big, fat, juicy bubble before we can get set for a tremendous crash.

Remember, it has always been in a rising rate environment that stocks have crashed and stock bubbles have burst. The only bubble that seems apparent is in the bond market. Prices of bonds everywhere have rallied, especially higher quality bonds. A bond paying 0% is better than a bond paying -0.5%, so surely bonds paying 1% are going to be in great demand.

In managing our clients' money, we are very leery about investments with unusually high rates. This almost always indicates a lower quality investment, and thus usually carries with it higher risk.

Over time, we might expect that negative rates will drive more money into investments and out of cash, which should buoy all boats. At some point these central banks will be looking to reverse their actions and start raising rates. When that occurs, we will be on notice to begin looking for bursting bubbles, not just in bonds, but in stocks and real estate as well.

The views and opinions are those of J. Kevin Meaders, J.D.*, CFP®, ChFC, CLU and should not be construed as individual investment advice, nor the opinions/views of Voya Financial Advisors. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. Additional risks are associated with international investing such as, currency fluctuation, political and economic stability, and differences in accounting standards. Investors cannot directly invest in indices. Past performance does not guarantee future results.

Source: Kevin@Magellan Planning Group, Inc.