With an estimated US$12.5 trillion worth of global bonds trading at negative interest rates, how long will it be before New Zealand also has negative rates?
What impact are these sub-zero rates having on financial organisations, the global economy and on investment markets?
The conventional belief was that interest rates could never go below zero because, if this occurred, depositors would rush to their banks and convert their holdings into cash.
Accordingly, American economist Kenneth Rogoff argued that negative interest rates would only be practical once cash became obsolete.
Although the use of cash is decreasing, it is still in circulation. Nevertheless, the zero-interest floor theory was demolished on July 5, 2012 when Danmarks Nationalbank, the Danish central bank, cut its certificates of deposit (CD) rate from a positive 0.05 per cent to minus 0.20 per cent.
Denmark is an EU country, with its own currency, and the main objective of this decision was to ensure the currency didn't trade above its narrow range with the euro.
The negative CD rate meant that Danish banks had to pay for the privilege of depositing money with the country's central bank.
The European Central Bank (ECB) followed suit on June 5, 2014 when it cut its deposit rate for banks from zero to minus 0.1 per cent. The negative rate was introduced to encourage banks to lend to businesses rather than hold on to their money. The ECB wanted to encourage bank lending because it was concerned about low economic growth, high unemployment and deflationary risks.
Analysts were sceptical about this ECB move because negative interest rates had an adverse impact on Danish bank profitability, although they had helped lower the value of the country's currency.
The ECB made further rate cuts of 0.1 per cent in 2014, 2015 and 2016, bringing its deposit rate for banks to minus 0.40 per cent.
The Swiss and Japanese central banks also introduced negative interest rates during this period.
In 2015 the Swiss National Bank introduced a minus 0.75 per cent rate on deposits it received from commercial banks. Since then Swiss retail deposit rates have been mainly negative or zero.
However, there is a big difference between absolute and real interest rates, with the latter being adjusted for inflation. Switzerland had zero or negative inflation in the five-year period between 2012 and 2016, with consumer prices falling 1.1 per cent in 2015.
Thus, while Swiss deposit rates have been negative in recent years, they have been positive in real terms for part of this period because of the country's negative inflation rate.
There hasn't been a major outflow of money from Swiss banks because savings, held in the form of bank deposits, have often fallen by less than the price of the goods that this money can buy.
However, banks in most other European countries haven't reduced retail deposit rates below zero for two main reasons.
First, inflation has been positive in most countries and any interest rates below zero would be negative in real terms. In addition, cash remains a viable option and retail investors can convert bank deposits into cash if interest rates fall below zero.
Obviously, interest rates on corporate and government bonds aren't subject to the same considerations as large investors don't convert bonds into cash when yields turn negative.
A recent ECB study of 252 euro-area banks concluded that banks relying on retail deposits have increased their lending to households and enterprises under a negative interest rate scenario. This observation highlights the fact that the ECB's negative interest policies have been largely successful.
The ECB's deposit facility interest rate remains at minus 0.40 per cent while its two other interest rates — on the main financing operations and on the margin lending facility — are zero and 0.25 per cent respectively.
Meanwhile, most European retail deposit rates are zero or slightly above, while more than 50 per cent of European government bonds are trading on negative yields.
German, French, Dutch and Swiss 10-year government bonds are all transacting on negative yields while 10-year bonds issued by the Greek Government are trading on a yield of 2.02 per cent. Just over four years ago Greece was a basket case with its 10-year government bonds yielding 14.6 per cent.
It is hard to believe that US 10-year government bonds are yielding 1.89 per cent at present while Greek 10-year government bonds are trading only slightly higher at 2.02 per cent. The recent general election in the European country has contributed to this narrowing gap.
Japanese commentators, who have had long experience of low interest rates, warn that low and negative rate policies can have undesirable consequences.
Japanese investors have ditched their home bias and invested in global stocks, bonds, property and speculative assets.
A recent Bloomberg commentary on Japan noted: "As the quest for returns gets more desperate each year, popular trades become crowded, driving even the most conservative investors into riskier assets. And there's a great danger of swings in currencies or monetary policies sparking sudden volatility in prices and money flows".
Meanwhile, the Reserve Bank of New Zealand (RBNZ) cut its official cash rate (OCR) to 1.5 per cent in May and NZ government 10-year bonds are trading at 1.4 per cent.
Even though the RBNZ has indicated that its OCR could go as low as minus 0.75 per cent, it is highly unlikely that New Zealand retail deposit rates will go negative for several reasons, including:
• Unlike Switzerland, New Zealand has a positive inflation rate of 1.7 per cent and the Reserve Bank's latest Monetary Policy Statement said that measures of core inflation had gradually increased and inflation expectations "have been well anchored to the 2 per cent target mid-point". The statement contained a 1.6 per cent inflation forecast for the 2019 calendar year, 1.8 per cent for 2020 and 2.0 per cent for 2021.
• Although New Zealanders are rapidly moving away from cash, it is still used by older individuals who hold substantial bank deposits. If New Zealand retail deposit rates go negative, while consumer prices continue to rise, then older bank customers will convert bank deposits into cash. This would have a major impact on the banking sector, although the banks will be in a much stronger position after bank cards have replaced cash, possibly by 2030.
• There are also complex technical difficulties, including the RBNZ's exchange settlement account, that constrain the central bank from introducing negative interest rates.
Although New Zealand interest rates are not expected to go below zero, they could fall further. It is not inconceivable to see the NZ government 10-year bond yield and retail deposit rates falling below 1.0 per cent, particularly if the domestic economy slows, inflation remains low and the RBNZ has further OCR interest rate cuts.
Low interest rates put huge pressure on superannuation and pension funds, as well as insurance companies, because these entities are heavily dependent on high yielding bonds to generate investment returns.
Low and negative interest rates also encourage individuals to invest in highly priced and risky assets in their search for yield.
There is clear evidence of this at present as far as property and infrastructure stocks are concerned, and the low yield on government bonds, including bonds issued by Greece and other highly indebted nations.
The best advice for investors, particularly those with a traditionally conservative approach, is to accept the current low-interest environment and avoid taking on too much risk in their quest for higher yields.
- Brian Gaynor is a director of Milford Asset Management.