Negative rates, negative news

We are truly in an extraordinary environment when many real interest rates are negative – that is, inflation is higher than the rate being offered on securities like government bonds.

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Such low rates have both short and long-term implications. But in the short term one risk is to bank profits. And in the long term there are also risks to bank profits.

"Not all financial institutions have the systems ability to populate their spread sheets with negative numbers."
Andrew Cornell, Managing Editor, BlueNotes

Negative rates are not unprecedented, Japan for example sounded these depths more than a decade ago.

But this time around the negative rate environment is more pervasive, more entrenched and more concerning. Once again, as in the period in the run up to the financial crisis, yields on debt no longer reflect true risk because the market demand for higher-yield instruments trumps the risk characteristics.

These extremely low rates have also been less than effective in forcing individuals and institutions to seek out more productive investment options – a reflection of the dire state of Keynes’ “animal spirits” in the global economy.

Instead, fears are rising of asset bubbles as the lower funding costs of borrowers translate into more speculative investment based on greater levels of leverage – which obviously is also more vulnerable to rising rates.

There are also some lesser appreciated, mechanical challenges: not all financial institutions have the systems ability to populate their models and spread sheets with negative numbers.

That then is a genuine cause for operational risk concern.

Some observers have – rightly – pointed to the ongoing inflation risk consequent to such ultra-low rates, amplified by the tidal force which will occur if lending in the real economy manages to gather some momentum.

There is too the obvious credit risk of whether economies which have become used to low and negative rates can cope with rate increases when they come – both individually and indirectly if capital rapidly shifts because, say, the US Federal Reserve lifts rates before Europe.

As rates rise, the theory goes, bonds get sold off and investment shifts into the real economy. In theory. But as several central bankers have warned, the shift itself away from low and negative rates is unlikely to be smooth.

What will central banks do if inflation – a bit of which they want at the moment – suddenly starts to take off?

These scenarios are all potential risks to financiers as a likely consequence is higher bad debts as borrowers struggle to cope with higher funding costs.

For the moment though, there are other implications from such low rates for the financial services sector. One is negative spreads, where institutions such as pension funds which typically hold low risk assets like government bonds cannot generate enough yield to offset their liabilities.

This too first occurred in Japan around the turn of the century when the insurance and pension sectors, which had guaranteed a level of return to customers, were unable to pay it as the Japanese government bonds they bought as assets yielded less and less.

Even if spreads are not negative, any time institutions are told to hold certain levels of certain assets, such as government debt, they must bear any cost of those assets earning less than a comparable investment vehicle. And government debt is the lowest earning asset on the block – particularly if you’re actually paying to own it rather than receiving a real rate of return.

In reference to Europe, where negative government bond rates and ample central bank money printing are most pronounced, the ratings agency Standard & Poor’s noted recently “the current pairing of negative interest rates and ample liquidity is a novel combination with major implications for commercial banks and for Europe's entire financial system”.

Again, in theory, if bank funding costs and government debt yields fall together, there is no major implication. The problem comes when they disconnect, when government bonds – which institutions must hold as safe assets in their liquidity portfolios, for example – fall faster than funding costs. That creates a margin squeeze – one which has already been evident in the trading books of banks in Asia even though official debt is not at negative rates in this region.

The so-called “cost of carry” becomes more expensive. There is a rolling cost too. The price of debt is the opposite to the yield it offers (which makes sense when one considers the value of debt is the principle and accumulated interest payments over time).

So if the low rate environment persists, banks are paying more to replace higher yield portfolios they are currently carrying. As more cheaper debt matures, it is replaced by more expensive (lower yield) debt to keep regulators satisfied.

According to S&P, “we expect the overall impact on (European) banks' profitability to be moderately negative, with variations among the different jurisdictions”.

“Most European banking sectors are primarily deposit-funded and deposit margins across the sector are likely to suffer,” the agency said. “Banks generally hold government and covered bonds (among others) in their liquidity portfolios and the compression of yields will add to banks' earnings pressure.”

S&P expects banks to respond by raising rates and fees and it also expects funding costs to fall, providing some offset. Overall though it notes “the search for yield is set to intensify, further fuelling the bond, equity, and potentially real estate markets, increasing overall risks in the financial system and setting the stage for sudden corrections in the future”.

Banks globally, including in Asia, are not quarantined from this potential credit risk. Even in Australia, where real rates are still positive and there has not been a recession, corporate recovery experts believe it is only the very low rates which are keeping some companies afloat.

For all banks, the margin impact of ultra low rates is immediate and becomes more pronounced the more of such low yield debt banks hold – or are required to hold.

And the new wave of global regulation is forcing banks to hold more and more of such debt, particularly in their liquidity books where government bonds are the most desirable asset – which of course creates higher market demand driving yields even lower.

Two broad scenarios then present themselves: negative rates and quantitative easing by central banks finally work to generate investment and spending in the real economy and some inflation. Rising rates initially hurt the asset value of financial institutions but are better in the longer run.

Or these extraordinary measures don’t work, deflation becomes persistent, the quantum of debt, while at low rates, grows in real terms and the financial sector becomes exposed to greater credit risk in the years ahead.

Negative rates then are not great for financial investments.

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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