Video transcript is provided below:
What are negative interest rates?
Good evening! It’s another edition of the Dorr Report, and I am your host Jhordan Dorrington. Let’s dive right in.
There’s been a lot of talk about negative interest rates. Post-2008 quantitative easing included unconventional monetary policy that included dramatically lowering interest rates. And despite some promising signs of economic recovery since then, rates have generally continued to move lower, even past what we once thought was the lower bound, 0, and into negative territory. Japan, Sweden, Denmark, Switzerland and even the European Central Bank have now adopted negative rates.
Closer to home, in September 2019, Donald Trump, in his infinite wisdom, continued his bully-campaign on the Fed stating they should drop rates to 0, or less. The unhealthy relationship between the Fed and Trump aside, why would anyone, let alone the world’s central bankers, decide that paying someone to take your money is better than being paid to be a lender?
If I lent you money you would pay me back principal with interest. But in the world of negative rates, I would lend you money and expect less in return. It’s counterintuitive.
If Lady Gaga was coming to town and instead of paying to buy tickets, Gaga paid you to go to the concert. It would be a full house, but certainly this can’t be the new norm. The system wasn’t born this way and despite being on the edge of glory, it can trouble even the most sophisticated investors despite their best p-p-p-p-p-p-p-poker face.
So, how does this system work?
We know that lower rates are meant to stimulate the economy and higher rates are meant to slow things down, but where do negative rates come into the mix? Your local banks deposit their excess cash reserves at the central bank, and ordinarily earn a small profit for doing so. But with negative rates, those banks are now charged to store that extra cash. Rather than paying for their money to do nothing, local banks are encouraged to find other uses for that cash, and primarily turn to lending.
What are the knock on effects of this?
- Bank profitability falls as the margin between what they pay on deposits and what they earn from long term lending gets squeezed. In Canada, especially, where a big chunk of the economy is in financial services, it behooves everyone for the banks to continue to do well.
- Buying government bonds is considered the safest form of investment. If the safest thing you can do with your money is to lock in a loss, investors are forced to find increasingly risky investments to earn the same income. And although that is the point not everyone in the economy, like retirees, pensions and insurance companies, can safely absorb that extra risk. Grandma Gertrude can stamp bingo cards for fun, but probably a bad idea for income.
- Lower interest rates reduce demand for that respective currency. Canada has kept rates positive which means investing here is relatively more attractive. Investors would rather earn something in Canada than nothing elsewhere. That puts the Canadian dollar in demand, making it stronger but it also means that doing business with Canadian exporters just got more expensive. You might see more Maple Syrup from Vermont instead of Quebec around the world during pancake season.
What do negative interest rates mean for us?
Why would anyone choose to live in a bizzaro world like this? I speak with my esteemed colleague Brian Carney, Portfolio Manager at Canso Investment Counsel, who might shed some light on this.
Video transcript is provided below:
Jhordan Dorrington (JD): Brian, welcome to the show.
Brian Carney (BC): Great to be here, Jhordan. Congratulations on your new show.
JD: It’s good to have you. Brian, let’s dive right in to some questions. Understanding that there are some knock on effects to administering negative interest rates, why is this still an option for central bankers? Why are we seeing this across the globe?
BC: Well, the reality is central bankers have a limited number of options to stimulate economic activity. That’s their prime objective, and there’s no proof, at least as of yet, that negative rates do not work. So as long as central bankers believe lower interest rates stimulates economic activity it will still be part of their toolkit.
JD: Can you talk to me a little bit about investors and how long and negative interest rates not only affect what’s in their portfolio now but what they might be looking to buy in the near and medium future?
BC: You know, it’s a great question, because in these types of markets investors are really challenged when it comes to fixed income options, savings options, and I would say investors are broken up into two camps. There’s the one camp, relatively small, the cynical, skeptical investor who really can’t believe interest rates should be negative and therefore sits on the sidelines or takes a more defensive posture. And the other camp, which is probably much larger, that group of investors that doesn’t want to be left behind, and no matter how challenging the markets think they have a way to outsmart those markets. And unfortunately in a negative interest rate world it means buying securities that are already yielding negative returns and hoping that they yield even more negative returns and therefore realizing a capital gain on those securities.
So it’s a challenging market and unfortunately we think the skeptical investor is better positioned to weather it but there are fewer skeptical investors than the optimistic ones.
JD: FOMO. Fear of missing out.
JD: We haven’t seen negative rates here in Canada or in the United States, but we have seen it in Japan, Switzerland and in the Eurozone. How does this affect the North American economy and do we anticipate either the Bank of Canada or the Fed also adopting negative interest rates?
BC: The short answer is we don’t see either the Bank of Canada or the Federal Reserve taking interest rates into negative territory, and the reality is the economic situations that exist in Canada and the US versus Europe and Japan are in our view distinctly different. You’ve got very anemic economic growth in Europe and you’ve had that situation for a long period of time which is why the ECB and other Central Banks have taken rates into negative territory in an effort to stimulate positive economic growth and to bring at least a modest level of inflation back into Europe.
In Canada and the US, the economic situation is quite different. The GDP numbers are modest but still quite positive. Unemployment rates are very low by historic standards. So we don’t see the need to take rates considerably lower than where they are to stimulate activity because the economies actually are doing quite well on their own.
That being said, in the last several months the Federal Reserve has cut rates three times, total of 75 basis points or 3/4 of 1%, in what they are calling a pre-emptive move to hopefully stimulate even more economic activity. But again they are stimulation off a pretty positive base, so we don’t see the same negative interest rate phenomenon happening in North America as is happening in Europe and Japan.
JD: I guess what we all want to know is, how does this all end Brian?
BC: Jhordan, I wish I had the answer to that. And we’ll have to wait and see. The central bankers will have to wait and see. Unfortunately my view, and the view of the firm that I work for, is ultimately negative interest rates are unsustainable. At some point you will have to see a normalization of interest rates which means a move from negative to positive. And what means for investors in fixed income securities is significant capital losses, as securities that they bought with negative yields move to positive and the value of those securities fall significantly.
We think investors need to be very, very cautious because we don’t see how this ends well when rates ultimately normalize.
JD: And a quick follow up question and our last one, how can investors be positioning their portfolios now to protect against the normalization situation that you mentioned?
BC: Having said what I just said, I realize that’s quite Draconian. There are ways for investors to protect themselves and earn what are modest returns by historic standards and one of those ways is to buy higher quality, floating rate notes in Canada so you can earn yields somewhere between 2-3% in very defensive instruments – that’s positive 2-3%, not negative.
We would also caution against reaching for yield into lower credit quality instruments. So, non-investment grade securities, or what Michael Milken dubbed high-yield or junk bonds. You can earn higher returns on those in the short-term but we think long-term there’s a lot of risk in those markets. So we would urge investors to be more defensive in these types of markets and wait for markets to normalize and then take advantage of those opportunities.
JD: Thanks a lot for your time, Brian, I appreciate you being our inaugural guest and expert on the show.
BC: It’s been a real pleasure Jhordan, hope to be back.
JD: That was Brian Carney. Not everyone understands how this works and we certainly don’t know how it’s going to end. But, in the same way that an investor looks for the difference between price and intrinsic value we do encourage you to also look for the difference in what’s happening around you and what actually makes sense. Because in a world of corrections it seems to be not a matter of if but when.