In The New Frontier of Negative Rates and Banking, business expert witness Douglas E. Johnston writes:
While financial market observers in the US remain focused on the timing and magnitude of the Fed raising target interest rates over the months ahead, European bond markets have begun to experience just the opposite – the never-before-seen phenomenon of actual negative bond market interest rates. Since the Global Crisis of 2008, which saw both the Fed and foreign central bankers seeking both to calm markets and to encourage growth by reducing rates to the ‘zero bound,’ interest rates for bellwether German bonds and across Europe in late 2014 crossed into negative territory, and for the first time in world history. As noted recently by iconic market veteran Art Cashin, now Director of NYSE Floor Operations for UBS Financial Services, over 30% (approximately $2.2 Trillion) of the highest-rated sovereign debt in Europe now bears a stated negative interest rate. Over 70% of all German government bonds now carry negative stated rates, and there are indications these conditions may become even more wide-ranging and spill over to US markets. After more than six years of various central bank ‘Quantitative Easing’ (QE) stimulus programs including scheduled open-market bond purchases, negative interest rates now clearly constitute the ‘new frontier’ of central bank monetary policy. Numerous other policy implications regarding negative rates are still unfolding in an uncharted scenario, which even the founder of modern monetary theory, John Maynard Keynes, did not foresee.
In an environment of ultra-low and negative rates, non-interest-bearing asset classes including commodities should become more attractive. Therefore, one major historical disincentive to buying oil and gold, for example, may have been removed. Stated differently, increasingly negative interest rates should be positive for commodities, because the imbedded math suggests that an investor is effectively paid to hold them, as compared to holding negative-rate financial instruments.
Negative Rate Policies Have Major Implications for Commercial Banks
On the surface, negative interest rates represent a confusing and counter-intuitive ‘new math’ which can be difficult to grasp. Stated plainly, at least $2.2 Trillion of European bond investors are now paying for the guaranteed right actually to lose principal, and to receive back less than they have invested. This highly unusual scene seems to tell us that at least some sophisticated institutions are perhaps embracing the loss of some principal by investing with various sovereign governments, rather than face the loss of even more principal by making other types of investments. Viewed from a slightly different but equally important commercial bank perspective, negative rate monetary policy also seems very plainly to encourage far more aggressive commercial bank lending activity. Negative rates may serve to penalize banks which do not lend, or at least which do not lend to businesses in sufficient volumes to promote desired growth.
Bank lending to businesses has long been regarded as the grease of the wheels of commerce and growth since the days of Adam Smith. Unfortunately, for today’s central bank growth advocates, many commercial banks have been more reluctant to lend into the slowing-growth economies of the US and Europe, where lending activity has been essentially flat over much of the past five years, as compared to the higher-growth economies of the BRICS and other countries. Risk-averse banks have, in a way, preferred to lend their surplus funds to low-risk governments rather than to higher-risk businesses, yet now they may be penalized and urged to shift out of the lower-risk status quo. By adding a mathematical penalty to banks in the form of negative interest rates, the new paradigm thus has added implications which appear to run directly opposite to the risk-averse Basel I-III bank capitalization and risk guidelines which were introduced in 1985. The Basel Accords now carry the effective weight of core bank regulatory guidelines around the world. They are already well known and widely followed by and among the FDIC and metropolitan banks, as well as by virtually all community banks across the US. Changing the risk focus of central bank lending guidelines which have been built steadily and by global consensus over the past thirty years is certainly no small thing to consider.
Doug Johnston (through Five Management, LLC) is an expert witness in banking/lending and an investigative business consultant specializing in Commercial Banking & Lending, Private Equity, and International Banking.