Negative interest rates are becoming increasingly common but this phenomenon has not reached USA. Can it happen and if so, what are the implications?

History of interest rates

5000 year history of nominal interest rates (Source: daily reckoning)

The chart above documents nominal interest rates as far back as 3000 bc. For the last few centuries, interest rates have averaged around 4% and currently interest rates are as low as they have ever been. A new phenomenon is the emergence of negative interest rates. As noted in the article regarding safe haven assets, negative yielding sovereign debt only really took hold in 2014 and has been growing significantly since then. Why is this occurring? There are two factors: 1) the market itself bidding up the prices of bonds, and 2) central banks purchasing bonds. Both of these factors have the effect of pushing bond yields down.

Japanese Government bond yield curve 2012-2016

The above chart shows how the yield curve of Japanese Government bonds changed over time. In 2012 the yield curve was positive throughout, and steep. As quantitative easing was introduced, the curve moved closer and closer to zero on the short end. The curve also became less steep. The Bank of Japan introduced a negative interest rate policy in 2016, pushing the short rates into negative territory. As time went by, longer and longer rates became more and more negative, resulting in greater flattening of the yield curve.

German bond yield curve 2010 – 2020 (Source ECB)

Shown above is the equivalent chart for German bonds. In 2019 (pink line) all yields were positive and the curve was steep. As the short term rates fell into negative territory, at the long end of the curve yields fell by a greater amount. Successive flattening of the curve is observed because as time goes by, longer and longer maturity dates go into negative territory.

The phenomenon of negative interest rates is very bizarre and unnatural. Investors are effectively paying to lend out their cash. Yet this is occurring, and many countries around the world have had persistent negative rates for years.

Benefits of negative interest rates

  • Easier to service debt
  • Encourages lending/borrowing
  • Props up housing market
  • Encourages spending
  • Weakens currency
  • Boosts economy

There are some theoretical benefits of negative interest rates. Firstly it makes it easier to service large debts. Note that only banks and big corporations will benefit from borrowing at negative rates. For retail borrowers, the interest rate will still remain positive (albeit low).

If banks will be charged for holding cash, that it a strong incentive for them to lend rather than hold cash. In theory, people will be encouraged to borrow more but it is questionable whether this would work if people are already up to their eyeballs in debt and the economy is going down the gurgler.

Negative interest rates may also be beneficial in propping up the housing market. If negative interest rates are passed on to savers, that would be a disincentive for holding cash in the bank. In theory that would encourage spending. Paradoxically that hasn’t occurred yet in countries with negative interest rates.

Negative interest rates weaken the currency, and that is good for exports, and therefore good for the economy. On the flip side, a weaker currency makes imports expensive and boosts inflation.

Drawbacks of negative interest rates

  • Bad for bank profits
  • Band for pension funds and insurance companies
  • Bad for savers
  • Encourages physical cash hoarding

Negative interest rates also have their drawbacks. Bank profits suffer, as do the pension funds and insurance companies. Savers are punished for holding cash in banks and in theory this would encourage bank withdrawals and the hoarding of physical cash. This is unlikely to occur in practice since physical cash is being phased out in favour of digital payment systems.

Could negative interest rates come to USA?

The federal reserve have officially stated that they are not considering negative interest rate policy. The Bank of England have indicated that they are open to negative interest rates and the Reserve Bank of New Zealand has officially advised local banks to prepare their computer systems to handle negative interest rates by the end of 2020. If numerous central banks use negative interest policy, the effect will be a rise in strength of the US dollar. The Federal Reserve may decide to cut rates and go into negative territory to try and weaken the US dollar and thereby mitigate the fallout that comes with a strong dollar. Another potential reason the Federal Reserve might introduce negative interest rate policy would be to fight deflation. Negative interest rates theoretically counteract deflation due to the benefits mentioned above.

Japan and Germany seem to be managing reasonably well with negative interest rates. Would the effects be the same for USA? The big difference here is that the US dollar is the world’s reserve currency and is used for international trade. This is a very important point. All commodities are priced in US dollars and there has never been a time in history when the world’s reserve currency has been a fiat currency. The consequences of a negative interest rate on a reserve currency are completely unknown. However we can make some estimates regarding what could possibly happen in the world of commodities.

The concept of time preference will play an important part. Let’s use the example where someone comes to you asking to borrow a barrel of fuel and they can either return it the next day, or if you’re willing to wait they can return it in a month, and they will pay you $10 for your trouble. If you take the one month deal, you have what is called a low time preference. You are willing to put off owning the commodity now in the hope of being better off later.

In a negative interest rate environment, the offer would be quite different. The offer would be to return the fuel the next day, or if you wait a month the fuel would be returned but you would have to pay the borrower $10. In such a situation, you would naturally have a high time preference. You wouldn’t lend it out at all or if you did lend, you would want the fuel returned rapidly.

Note that we are talking about commodities which are necessities of life. That is a very different situation compared to the debt market. If the world’s reserve currency enters negative rate territory, commodities (including gold) will go into backwardation. It would be better to own a physical commodity now rather than holding onto cash deposits and taking possession of the commodity later. Therefore futures markets participants would be better off being long rather than short. That would cause commodity prices to rise. That would also be rocket fuel for gold.