The perverse consequences of negative interest rates are becoming more apparent with each passing day.
Fitch Ratings, the credit rating agency, cautioned on May 4 that negative rates are constraining the ability of long-term institutional investors to generate returns. This followed a warning by the Bank for International Settlements (BIS), the central bankers’ bank, in early March that “there is great uncertainty about the behaviour of individuals and institutions if rates were to decline further into negative territory or remain negative for a prolonged period.
According to Fitch, there is now nearly US$10 trillion of negative yielding government debt, almost 70 per cent of which consists of longer-term bonds. Japan accounts for more than two-thirds of the total, underpinned by the decision by the Bank of Japan (BoJ) in late January to introduce negative rates as part of its three-pronged monetary easing programme. Europe accounts for the remainder of sub-zero yielding sovereign debt, with the central banks of the eurozone and several Scandinavian countries having cut rates deeper into negative territory.
While central banks imposed negative rates mainly with the aim of forcing banks to lend more plentifully and cheaply in order to boost growth, the unintended consequences of sub-zero and ultra-low rates are eclipsing the supposed benefits.
Fitch notes that long-term investors, such as pension funds and life insurers, are struggling to generate the returns needed to fund their huge liabilities.
While the average yield on government bonds in developed economies five years ago was 1.23 per cent (and 1.83 per cent a decade ago), earning investors more than US$120 billion annually, it now stands at minus 0.24 per cent, costing long-term investors US$24 billion annually, according to Fitch.
This increases the scope for pension schemes and insurance firms to climb up the risk curve in order to generate returns. “The desire to generate better returns could lead banks, insurance companies and other investors to lower the average credit quality of their portfolios, contributing to higher risk in the global financial system,” Fitch warned.
The risk of asset bubbles is especially pronounced in the higher-yielding liquid debt markets of advanced economies, such as the US and the UK where yields on 30-year bonds have already dropped 40 basis points this year to 2.6 per cent and 2.3 per cent respectively.
A bigger danger is that negative rates in developed economies push pension fund managers and insurance companies into riskier parts of the capital markets in the hope of generating higher returns.
The OECD warned last year of “an excessive search for yield to match the level of returns previously promised when markets were delivering higher returns.” The shift into riskier investments is already taking place, according to the OECD’s private pensions unit, with stronger demand for so-called “alternative assets” such as high-yielding corporate bonds, private equity, hedge funds and commodities.
Indeed even in the countries where negative rates have been introduced, there are concerns about asset bubbles.
In Sweden, whose central bank cut interest rates to minus 0.5 per cent in February after becoming the first central bank to make its benchmark rate negative, policymakers face an acute dilemma, with inflation still less than half the central bank’s 2 per cent target despite a fast-growing economy fuelled by an extremely buoyant housing market.
Moody’s, another rating agency, warned in March that Sweden is “most at risk of an - ultimately unsustainable - asset bubble” stemming from “rapidly rising house prices and persistently strong growth in mortgage credit.” The Swedish central bank’s negative interest rate policy (NIRP) has further undermined the credibility of an institution that has already been severely criticised for raising rates prematurely following the global financial crisis and is now courting controversy again by cutting rates deeper into negative territory in the face of a mortgage boom.
Still, at least the ECB and the BOJ are increasingly wary of delving deeper into sub-zero territory given the fierce backlash against negative rates in Europe and Japan and, ironically, the pressure which excessively low rates are exerting on central banks’ own returns.
Among the largest long-term investors, central banks are being forced to change their portfolio management strategies, with reserve managers now more willing to buy riskier assets, according to a recent poll conducted by HSBC and Central Banking Publications, a trade journal.
With Moody’s warning on Tuesday that interest rates may never return to pre-financial crisis levels, central banks will be even warier of pushing rates deeper into negative territory.
Nicholas Spiro is a partner at Lauressa Advisory