In Netflix’s hit sci-fi series, Stranger Things, viewers are introduced to an alternate dimension known as the “Upside Down”—a dimension that exists parallel to the human world. It’s structurally similar, yet the conventional wisdom no longer applies. We find that the challenges faced by the show’s heroes draw parallels to those faced by many investors today following the introduction of negative interest rate policies (NIRP).

In the fourth-quarter Strategy Insights, we explore how we arrived at negative interest rates in select developed geographies, and the objectives and distortions of this unconventional monetary policy tool. We explore why we believe the United States may not necessarily follow others down the path of negative interest rates, and discuss the investment implications of NIRP. 

The Portal to Negative Interest Rates 

The portal to NIRP began more than a decade ago with unprecedented monetary policy actions taken by central banks in several developed economies. These central banks cut policy rates to zero, implementing zero-interest rate policy (ZIRP) and less-traditional monetary policy measures. As the recovery progressed, weaker and less consistent growth did not spur inflation to levels in line with many developed central banks’ price stability mandates. With policy rates already at zero, some central banks began to pursue nontraditional monetary policy measures, including NIRP. 

The portal to NIRP began more than a decade ago with unprecedented monetary policy actions taken by central banks in several developed economies.

Central Bank Policy Rates (as of 8/31/19)

View accessible version of this chart.

Currently, NIRP exists only in several developed regions, including the European Monetary Union, Denmark, Sweden, Switzerland, and Japan. But because most developed geographical regions have not entered the NIRP dimension, it remains the exception, not the rule. Growth and inflation are not nearly as scarce in emerging market (EM) countries, and no EM central banks have yet to approach the zero bound, let alone NIRP. Given the relatively higher growth and inflation rates of EM countries, we believe the idea of entering an Upside Down remains a distant thought for those countries.

Beware the NIRP Mind Flayer 

It’s difficult to draw definitive conclusions about NIRP’s success (or lack thereof) in achieving the objectives of reducing borrowing costs, stimulating borrowing, raising inflation, and depreciating currency. But there are some effects and unintended consequences of the negative interest rate experiment so far: 

1. Objectives/Distortions

Global borrowing costs. Lending rates for governments, consumers, and corporations have broadly declined since the policy’s inception. However, the impact of NIRP can be seen both within and beyond the countries where it has been implemented.

Stimulate borrowing or perpetuate deflationary expectations. The intention of NIRP is to help fuel greater demand for capital, which should translate into greater borrowing demands. The early evidence of negative interest rates stimulating the demand for capital has been mixed. 

The intention of NIRP is to help fuel greater demand for capital, which should translate into greater borrowing demands.

Inflation is the expectation, deflation is the reality. The European Central Bank implemented NIRP in summer 2014 and the Bank of Japan in 2015 in the hope of reigniting economic growth and increasing inflation to levels consistent with their mandates of price stability. However, 10-year inflation breakeven rates did not respond favorably to the policy changes. Inflation expectations have drifted lower in Europe and Japan ever since. 

The paradox of currency depreciation with NIRP. Some central banks have implemented NIRP with the stated intent of weakening their currencies. Economic theory suggests lowering interest rates should decrease the relative value of a country’s currency. This, in turn, should help make exports more competitive on the global stage and thus accelerate that country’s economic growth. However, these rules get distorted in a NIRP world.

Distortions/Reality 

Hoarding physical cash? There was speculation that NIRP would lead some depositors to hoard physical cash to avoid being charged interest on bank deposits. Today, retail deposit rates are still marginally positive across most NIRP regions, giving little incentive for depositors to spend or use their funds in ways that enhance productivity.

Banks caught between a rock and a hard place. Globally, bank profitability in NIRP regions has been challenged relative to regions where interest rates are still nominally positive. We believe the slowdown in economic growth has also played a factor. 

Bank EPS by Region (as of 8/30/19)

View accessible version of this chart.

Even lower for even longer for investors. The growing level of negative-yielding debt globally has led to behavioral finance distortions. NIRP has effectively pushed bond investors to trade on the singular hopes of price appreciation. It would be irrational for an investor in a NIRP region to buy and hold a negative-yielding bond. 

Is the United States Headed for NIRP? 

Could the United States also embrace NIRP and enter an alternate dimension of its own? Following are four key differences between monetary policies used in the United States and countries that have adopted NIRP, which suggests to us the United States is unlikely to pursue NIRP in the near future: 

  • Cumulative U.S. economic growth has outpaced both the European Union and Japan since the global financial crisis ended in 2009.
  • The United States has been more willing to use fiscal policy to stimulate growth. Fiscal policy can help stimulate economic growth by reducing taxes, industry deregulation, infrastructure investments, increasing government spending, and so on.
  • U.S. demographics pose relatively less of a headwind. We think U.S. demographic trends likely will be relatively more supportive for growth prospects and thus a lower probability of needing to rely on NIRP.
  • U.S. Inflation is close to the Federal Reserve’s target of 2%. Most central banks in the developed world have a 2% inflation mandate. However, they have persistently undershot this level throughout this economic cycle. The exception has been the United States, where not only has headline inflation exceeded 2% at times, but currently core (that is, excluding food and energy) is above its 2% target. With inflation this close to the Federal Reserve’s (Fed’s) target, we do not see any reason for aggressive policy accommodation along the lines of NIRP. 

Expected Decline in Working Age Populations in the U.S., EU, and Japan (Expected Decline in Working Age Population as Percentage of Total Population Ages 15–64)

Source: United Nations, Department of Economic and Social Affairs, Population Division (2017).

View accessible version of this chart.

Populations in the U.S., EU, and Japan (Expected Decline in Working Age Population as Percentage of Total Population Ages 15–64)]

In our opinion, the United States is unlikely to pursue NIRP in the near future. 

Potential Investment Implications 

How should investors reposition a traditional balanced portfolio in a NIRP world? Or should they? While we would steer clear of a dramatic shift in allocations, there are still options to consider at the margin. These are not formal tactical recommendations to make at this juncture, but in a low-NIRP world, certain asset classes would tend to be favorably positioned. Given we remain in the later innings of the cycle, we continue to prefer a tilt toward active management over passive implementation. 

When carefully selected, we believe alternative investments have the potential to add incremental return in a NIRP environment and can improve the overall risk profile of portfolios. Since alternative investments typically have a low correlation with public markets, they could be an appropriate way to diversify risk exposure, tap into new sources of yield, and decrease overall portfolio volatility. Alternative asset classes that could be beneficial to investors in a NIRP world include private equity, private debt, and private real estate.

 

TEXT VERSION OF CHARTS

Central Bank Policy Rates (as of 8/31/19)

Bloomberg Data Series       Aggregated Data Series    
Date   European Central Bank Bank of Japan Danish Nationalbank Swedish Riksbank Swiss National Bank
8/30/2019 8/19 -0.4 -0.1 -0.65 -0.25 -0.75
12/31/2018 12/18 -0.4 -0.1 -0.65 -0.5 -0.75
12/29/2017 12/17 -0.4 -0.1 -0.65 -0.5 -0.75
12/30/2016 12/16 -0.4 -0.1 -0.65 -0.5 -0.75
12/31/2015 12/15 -0.3 0.1 -0.75 -0.35 -0.75
12/31/2014 12/14 -0.2 0.1 -0.05 0 -0.75
12/31/2013 12/13 0 0.1 -0.1 0.75 0
12/31/2012 12/12 0 0.1 -0.2 1 0
12/30/2011 12/11 0.25 0.1 0.3 1.75 0
12/31/2010 12/10 0.25 0.1 0.7 1.25 0.25

 

Bank EPS by Region (as of 8/30/19)

Date MSCI Japan Index - Banks MSCI Europe Index - Banks S&P 500 - Banks
8/19 102.39 104.39 162.38
6/19 102.42 104.63 162.94
3/19 95.51 108.29 163.54
12/18 106.91 107.21 149.81
9/18 102.68 107.53 149.13
6/18 102.6 106.98 147.76
3/18 105.14 106.78 147.24
12/17 103.42 100.07 116.96
9/17 99.33 100.46 116.65
6/17 98.85 98.05 115.14
3/17 104.4 95.96 114.2
12/16 106.18 82.35 103.14
9/16 100.69 83.36 99.1
6/16 103.2 85.41 100.25
3/16 112.92 97.1 103.37
12/15 115.21 108.65 103.94
9/15 112.44 110.03 105.26
6/15 109.6 114 104.1
3/15 109.58 113.96 104.63
12/14 106.06 97.52 100.46
9/14 100 100 100

 

Expected Decline in Working Age Populations in the U.S., EU, and Japan (Expected Decline in Working Age Population as Percentage of Total Population Ages 15–64)

Year Country Percent of Total Population,
Ages 15-64
1950 Japan
Europe
U.S.
59.72
65.71
64.96
1975 Japan
Europe
U.S.
67.89
64.81
64.26
2000 Japan
Europe
U.S.
68.23
67.69
65.98
2025* Japan
Europe
U.S.
58.30
63.16
63.08
2050* Japan
Europe
U.S.
51.07
57.16
60.68

*Estimate

FOR AN IN-DEPTH LOOK
Strategy Insights: Q4 2019