What Happens if Interest Rates Go Negative?
John Fischer, CFA®, CFP® | Chief Investment Officer
June 24, 2020
With the unprecedented economic uncertainty around the globe and U.S. interest rates hovering near historically low levels, more investors are starting to ask the question will interest rates in the U.S. go negative? If so, what would the effects be? With the 5 year treasury bond yielding 0.30% and the 10 year yielding 0.70%, it’s a reasonable question for investors to pose.
Fed Chairman Jerome Powell has shared in testimonial that the Federal Reserve doesn’t believe that negative interest rates are a good policy tool and while they did cut rates to zero in March, they’re unlikely to go lower. Let’s take a closer look at the risks of negative interest rates to better understand the Fed’s perspective.
- Negative Interest Rates Punish Savers – You’re used to earning interest when you deposit money at the bank. Imagine paying the bank for the right to deposit and keep money in your savings account – sound more than a little strange? Negative interest rates would punish responsible savers and disincentivize them from keeping money in the bank. While one might argue that would encourage consumers to spend, it might send the contrary message that if the economy is so bad that rates are negative, consumers better sit on their money and wait for the darker days ahead.
- The Banking System Splinters – Without sufficient deposits from customers, banks lack the funds to make loans (to small businesses, for houses, cars, etc.) and the banking system begins to crack. Think the bank wants to pay you interest for your mortgage? If rates were sufficiently negative, the bank would be paying borrowers who were granted a loan. This type of environment would disincentivize banks from making loans and extending credit, putting immense pressure on the banking sector that is the foundation for the U.S. economy and pushing the country towards a cash-only system.
- Stripping the Toolbelt – Historically, the Fed has exercised its ability to lower interest rates during tough economic times to incentivize spending and sustain the economy. Persistent negative interest rates, and even ultra-low positive rates, can leave the financial system even more vulnerable because it exhausts one of the Fed’s primary tools in supporting the economy when it falters and needs additional support.
- Sending Consumers the Wrong Message – While negative rates are intended to give a positive jolt to the economy by encouraging spending, they could have the opposite effect. Studies of countries like Japan who have already embraced negative interest rates for some time suggests that the extreme policy could have investors interpreting the policy as the canary in the coal mine – an indicator that the central bank knows something the public doesn’t and that the worst is yet to come. This type of behavioral perception could cause investors to hold onto cash and wait for more bad news, which runs in the face of the intended result of a negative interest rate policy.
- Pension Plans Threatened – Determining whether a pension plan is properly funded is reliant upon discounting the pension’s future liabilities to present day, using an appropriate discount rate. The further interest rates decline, the greater the pension’s estimated liabilities are in today’s dollars. Larger liabilities increase the risk that a pension plan will be underfunded, meaning the pension’s liabilities exceed its assets. Underfunded pension plans create considerable risk to those people reliant upon pension plan payments.
With countries like Japan and many in the eurozone already embracing negative interest rate policies, there are clearly parties on both sides of the argument regarding the benefit of negative interest rates. Fed Chair Powell recently opined that “there’s no clear finding that it (negative interest rates) actually does support economic activity on net, and it introduces distortions into the financial system, which I think offset that.” Given Chair Powell’s perspective, I think it should be clear to investors that the Fed is likely do everything it possibly can to avoid negative interest rates.
Important Disclosures: The opinions voiced in this material are for general information only and should not be construed as personalized investment advice, including the recommendation to engage in a particular investment strategy. The information contained herein has been obtained from sources deemed reliable but is not guaranteed. Rates quoted within are subject to change and, as such, may no longer be accurate.