Are financials feeling the effects of negative rates?
The Bank of Japan recently joined a handful of central banks by cutting interest rates into negative territory. Are the unintended consequences of these moves contributing to weakness in financial stocks?
15 February 2016
The Bank of Japan (BoJ) surprised markets by cutting rates into negative territory in late January, joining the ranks of the European Central Bank (ECB), the Swiss National Bank and the Riksbank, the central bank of Sweden. The benchmark 10-year Japanese government bond yield reacted accordingly, falling below zero to -0.05% (as of 9 February 2016), making Japan the first major economy with a negative yield on 10-year government debt.
Figure 1: Benchmark 10-year government bond yields
Source: Thomson DataStream, Schroders Economics Group, updated 10/02/2016
While below-zero central bank policy rates may bring about benefits for governments through lower borrowing costs, the banking system’s profitability may suffer as a consequence. Broadly speaking, negative deposit rates are designed to force banks to lend money to riskier borrowers and invest funds in higher risk assets to compensate them for the hit to their net interest margins. Many banks have chosen, however, to not pass on the costs of negative rates to customers, instead absorbing much of the cost themselves. Such concerns about bank profitability have been a contributing factor to the recent selloff in financial stocks.
Do long-term negative rates present contagion risk?
Prolonged periods of negative interest rates also have wider implications for the financial sector. Important market intermediaries in the form of money market funds will also face downward pressure on profitability as investors allocate capital to alternative segments of the market. If negative rates continue for the foreseeable future, many money market funds may be forced to close. Other non-bank financial institutions that may feel the squeeze from prolonged negative rates include pension and life insurance companies. Negative rates increase the threat of failing to meet long-term liabilities, particularly if institutions are constrained to hold government bonds due to regulation.
Finally, if yields fall further below zero this may create an environment of excessive risk taking. In search of positive yield, investors may be forced to take ever increasing riskier positions to earn their required return.
The counter argument to this is that investors interpret negative yields as a chronic weakness in the global economic position. Within the $23 trillion universe of developed market government debt tracked by JP Morgan, $6 trillion (as of 9 February 2016) trades with a negative yield, which equates to just shy of one third of the market. This can be taken as a reflection that global growth remains weak by historical standards and that many economies are failing to generate meaningfully positive inflation.
Figure 2: Global bonds with a negative yield in JP Morgan Government Bond Indices
Source: JP Morgan, Schroders Economics Group, updated 10/02/2016
In such an environment, capital would flow to safe havens pushing yields further into negative territory.
Are negative yields here to stay?
This is exactly what appears to be playing out in markets at the moment. For example, in equity markets, defensive stocks such as pharmaceuticals have so far outperformed the likes of financials by a considerable margin in 2016. So far the action by the BoJ has not delivered a weaker yen, raising the possibility of further rate cuts by the central bank. If so, then other central banks may be obliged to follow a similar path and take rates into unchartered territory.
In summary, while widespread negative rates represent a new economic experiment, they may be placing strains on the financial sector that are yet to be fully appreciated.
 Money market fund: an open-ended mutual fund that invests in short-term debt securities such as bonds.
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