Practical analysis for investment professionals
23 July 2019

Negative Interest Rates: Carry an Umbrella at All Times

Bankers Stunned as Negative Rates Sweep across Danish Mortgages.

Yes, this sensationalistic headline is true. Negative interest rates are available in Denmark on adjustable-rate mortgages with durations under five years. So after paying some upfront fees, borrowers on these loans effectively receive a thank you payment from the bank every month.

How can this be? Why would lenders pay borrowers instead of charging them interest? To describe this upside-down world, the Mock Turtle in Alice’s Adventures in Wonderland would say “Well, I never heard it before but it sounds uncommon nonsense.”

So how did negative interest rates come about? Should portfolio managers change their game plans because of them? And if so, how?

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Let’s review the history. Negative interest rates first became a major phenomenon in 2014 when the European Central Bank (ECB) decided to pay commercial banks a negative rate on the deposits they held at the ECB. The Bank of Japan (BOJ) followed suit. These actions led to negative rates on European and Japanese government bonds. Over the years, the value of negative-yielding bonds has soared, going from zero to over $12 trillion.

Central bankers are encouraging savers to spend their money or invest it in something riskier than bank deposits and money market funds because they are obsessed with generating economic growth. They worry that anemic expansion will lead to deflation and that deflation will create a downward spiral of more negative growth and more deflation, as it did during the Depression era of the 1930s. By forcing savers to spend and invest, the bankers hope to spur economic growth and stave off the dreaded deflationary spiral.

Have these efforts succeeded?

Growth in Europe and Japan has actually been tepid, calling into question the wisdom of the negative interest rate policy (NIRP). In their defense, the central bankers contend that growth would have been even worse and that the economy could have plunged into the dreaded deflationary spiral had they not adopted such drastic measures.

There is no firm consensus on how these monetary policies affected economic growth. But there is broad agreement that they have indeed propped up the prices of stocks, bonds, real estate, and other risky assets over the last few years.

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The US Federal Reserve moved in tandem with the ECB and BOJ for many years following the global financial crisis (GFC). But thanks to stronger growth in the United States, the Fed diverged from its counterparts and raised short-term interest rates up until the beginning of this year. In recent months, the Fed has signaled that it will once again start cutting rates due to concerns about weaker economic growth.

In light of central bankers’ aggressive activism to drive interest rates so low, portfolio managers should consider the following questions and our subsequent analysis:

Will central banks reduce interest rates further? How low can they go?

Yes, more rate cuts are likely. Recent statements from Jerome Powell, Mario Draghi, and Christine Lagarde clearly indicate as much. They will keep going until one of two things occur:

  • Either economic growth increases and inflation is consistently above the 2% target,
  • Or something breaks in the financial system that sends the clear message that the market will not tolerate such low interest rates.

Are there downsides to the central banks’ recent measures?

The negative consequences are well-documented. Loose monetary policy has introduced market distortions, artificially incentivized risk taking, penalized savers, increased inequality, and strained pension funds. In some cases, those suffering from these effects have also benefited from higher asset prices and lower interest costs. Still, the doomsday scenario that experts feared most — runaway inflation — hasn’t materialized. Yet.

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Should portfolio managers consider adjusting their investment strategies?

Yes, portfolio managers should think about these monetary policies and their likely future path and determine whether their clients have a sufficient margin of safety if the gathering clouds threaten to burst. Below are our offer specific suggestions and the rationales behind them.

Equities: We recommend underweighting both debtors and creditors, unless their valuations become more compelling. Why? First, because many highly indebted companies have survived thanks to low interest rates. A business that relies on the mercy of the central banks is not an advisable one to own. As for the creditors, or banks, low interest rates reduce their profitability. Moreover, since banks apply substantial leverage in their business, they will be the first line of defense should the financial system start to take on water. By contrast, we see less downside in overweighting companies with stable, free-cash-flow-generating businesses with moderate levels of debt and reasonable valuations.

Fixed Income: Instead of the conventional path of intermediate duration, investment-grade corporate and mortgage-backed bonds, we suggest designating a portion of fixed-income assets to Treasuries as a hedge against deflation. The capital preservation portion of the portfolio should be Treasuries only, rather than broadly diversified money market funds. Those concerned about the possibility of runaway inflation should also consider investing in Treasury Inflation-Protected Securities (TIPS).

Real Assets: We advise gaining some exposure to real (physical) assets — commodities and precious metals, for example — and companies that own such assets. These provide diversification benefits and some, like gold, have potential safe-haven properties. Over the last few decades, modern portfolios have shunned gold because it doesn’t produce any income and, therefore, the opportunity cost of holding it was significant. In the current era of low and negative interest rates, that opportunity cost is less of a factor, thus highlighting gold’s diversification benefits.

Of course, one last question is worth considering:

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Could concerns about these monetary policies turn out to be unnecessary?

Yes, that is is indeed possible. The central banks might successfully engineer economic growth, generate moderate but manageable inflation, and revert to a narrow, safety-focused mandate rather than their recent activist, growth-at-all-costs approach. But if recent experience is any indication, we doubt that they can achieve such nirvana. So we need to be prepared for the possibility that their efforts won’t succeed. Fortunately, the cost of preparing for such a disruptive scenario is minimal at this time.

Our portfolio strategy recommendations do not require an ultra-conservative, rush-to-cash approach. Neither do we advise any drastic actions with significant real or opportunity costs. Indeed some defensive investments — gold mining companies, for example — may be undervalued, thus allowing us to harvest low beta at a low price.

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In Summary

The stock market’s recent performance combined with low unemployment may, at first glance, suggest that the economy is on the upswing and that there is nothing but blue skies ahead. If we stick our heads out the window, it might look like a clear day. Nevertheless, we recommend carrying an umbrella. Right now, it doesn’t cost much and it may come in handy if it starts to rain.

If we wait until the storm comes, it might be too expensive or too late and we risk being caught unprotected in a downpour.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images/Clarke Elsby / EyeEm

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About the Author(s)
Gautam Dhingra, PhD, CFA

Gautam Dhingra, PhD, CFA, is the founder and CEO of High Pointe Capital Management, LLC. He developed the firm's pioneering investment approach based on the concept of Franchise Quality, and under his leadership, High Pointe has built an enviable investment performance record. Dhingra served on the faculty member at Northwestern University’s Kellogg School of Management for two years. In this role, he designed and taught The Business of Investing course in the school’s MBA curriculum. His research interests include ESG investing and valuation of intangible assets. He holds a PhD in finance, with specialization in investments and econometrics, from the University of Florida’s Warrington College of Business. At Warrington, he taught two courses in securities analysis and derivatives.

Christopher J. Olson, CFA

Christopher J. Olson, CFA, is a principal and portfolio manager at High Pointe Capital Management. Prior to High Pointe, he was a portfolio manager at Columbia Wanger Asset Management in Chicago for 15 years where he managed both equity and balanced mutual funds. He began his investment management career at Yasuda Kasai Brinson in Tokyo in 1991, and later joined the parent company, Brinson Partners, to help start the firm’s emerging markets investment strategy. He has lived and worked in Sweden, Japan, and Taiwan. He is proficient in Mandarin Chinese and has studied five other foreign languages. Olson received an MBA from the Wharton School of Business with distinction and an MA in international studies from the School of Arts and Sciences, both at the University of Pennsylvania. He graduated from Middlebury College with a BA in political science, summa cum laude. He earned his CFA charter in 1998 and is a member of CFA Chicago. His civic responsibilities include his role as chair of the board at Swedish Covenant Hospital in Chicago and as trustee at Lincoln Academy in Maine.

8 thoughts on “Negative Interest Rates: Carry an Umbrella at All Times”

  1. Charles Self says:

    We agree with the above comments. In fact, we published a paper advocating the replacement of international bond funds with precious metals bullion funds (see website link.)

  2. Low R says:

    Low interest rate is an addiction. Take a look a the Fed fund rate, after every financial crisis/recession, the Fed increased interest rates but it never recovered to the previous levels. It seems businesses and even governments prefer interest rate to stay low for the long run. It is easy to understand why businesses prefers low interest rates. As governments around the world are more and more in debt, raising interest rate would increase governments’ interest cost. I guess, no government would like to pay more. Any comment(s) is (are) much appreciated.

  3. James Weir says:

    You say investors have been “artificially incentivized” to take risks, which implies interest rates are artificially low. But what evidence is there that’s in fact the case? We’ve had ultra low rates for years now, and people have been making that same argument the whole time, yet neither growth nor inflation are abnormally high, indeed, the usual observation is they are both surprisingly low. Are you sure you’re not just influenced by anchoring bias when it comes to what interest rates ‘should’ be? Similarly, your comment that equities markets are factoring in “nothing but blue skies ahead”, perhaps overlooks the possibility that very low risk-free returns are what lies ahead. If your real risk-free return is all but zero, equity PEs can theoretically go to infinity. And if you look at the ERP and earnings yield, they are both in line with post-GFC averages. There are still marginal dollars that are seeking a return above zero, and while equities offer even a little bit of growth, that makes them the tallest, and most attractive, dwarf. In other words, ultra-low inflation together with modest economic growth, means close to zero bond yields and elevated equity valuations can comfortably co-exist. By the way, you also commented that managers should avoid owning overly indebted companies: when was it ever not thus?

  4. Amin Ouardi says:

    We often hear the need for growth and the paradox of thrift as a justification for low rates but so far this cycle it does not seem to work… despite an aging population and a rising number of retiree, both Japan and Germany have seen a rise in household savings since adopting negative rates which, obviously, is not the desired outcome of such policy. Maybe we should start talking about the paradox of cheap money.

  5. Art says:

    “borrowers on these loans receive a check from the bank every month as a thank you payment.”

    Is this how it actually works? Or are these loans just self-amortizing (at the bank’s nominal expense) to some extent?

  6. Mike Bravo says:

    If the time value of money is zero or even negative, what is the point of doing any financial analysis other than to pick the least worst alternative. Negative rates are a value destructive exercise that will lead to financial collapse through severe mal-investment.

    But I know we are heading into peak absurdity when actuaries start telling me that pension liabilities will be discounted at negative rates should rates on High Quality corporate bonds go negative.

  7. I disagree with the explanation that the cause of low interest rates are the central banks.

    In my view, there are three drivers that lead to low interest rates:

    1 – ageing population: as population ages, consumption and expenditure decrease. Interest rates need to be lowered to increase the consumption of other younger people to offset this effect.

    2 – globalization and the China effect: globalization increased competetion and lead to lower prices for transactional goods. China basically exported low inflation around the world, by producing quality goods at a cheap price. If one would spend 1k usd on a TV, now one spends much less and the money left is extra savings, which pressures interest rates to a lower level.

    3 – technology and advancements in regulation: a bit related to the point above. Nowadays it is much cheaper to produce several goods, and the quality keeps getting better. Due to technology and better regulation, one can open a new business fast with much less initial capital. A lower demand for capital lead to lower demand for loans, so interest rates have to get lower to put things in equilibrium.

    Those three causes above are structural, and it will take time to change them so interest rates rise once again.

  8. Valentin Brescan says:

    Very interesting article. I agree it does encourage more risk taking. I think eventually either inflation will pick up, and the normalisation of interest rates will feed through valuations much faster than during the cuts period, or, if interest rates stay low for long enough, lending standards will start to weaken, and there could be adverse credit events, with hail rather than rain for the economy.

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