Interest rates – not as simple as you might think…
It may seem like a while ago but there was a time when the foundations of finance and economics were clear and straightforward.
‘Interest’ was a reward that you would get in return for taking the risk of lending your money to a debtor or depositing your capital in a bank.
Yet ever since the financial crisis hit back in 2008, it’s become apparent that things are not always so simple. We are starting to talk about negative interest rates, which some nations already have in place and there is speculation that the UK might be next.
What would negative interest rates mean for savers?
In more than three centuries of history, the Bank of England (BoE) has never seriously considered negative interest rates, at least not publicly. But with its benchmark policy rate currently at 0.1% and the BoE’s own forecasts [1] suggesting the UK could face its worst recession in 300 years [2], policymakers have admitted that this once unthinkable option is now under review.
On 20 May, BoE Governor Andrew Bailey told the Treasury Committee that the Monetary Policy Committee (MPC) was “looking very carefully” [3] at the impact of negative interest rates in other parts of the world, adding that it would be “foolish” [4] to rule it out as a potential policy tool. Bailey and other members of the MPC have since stressed that they are reviewing all aspects of the policy toolkit and not anywhere near making a decision on negative rates [5]. However, the soft pivot in tone – Governor Bailey had previously said that negative rates were not being contemplated – has raised interest in the potential impact this move could have for investors.
Why would a central bank impose negative rates?
A negative interest rate policy (NIRP) effectively charges commercial banks to deposit reserves at the central bank.
The aim of levying this penalty is to encourage banks to use their funds to lend to households and businesses instead, thus stimulating the economy. Negative rates on cash, which are likely to feed through into government bond yields too, also encourage savers to invest in riskier assets, thus providing additional capital to economic actors. Another objective may be to put downward pressure on the local currency to protect or stimulate exports, though few central banks would explicitly admit this.
Though traditionally considered a last resort, both the European Central Bank and the Bank of Japan have adopted NIRPs in the last few years in order to support their challenged economies. Central banks in Switzerland, Denmark and Sweden have also held borrowing costs below zero over the last five years, though Sweden’s Riksbank brought its main repo rate back to zero at the end of 2019 [6]. The BoE is now reviewing the experience of negative rates in these countries, with Bailey noting that there were “mixed reviews” over their effectiveness to date.
How does it affect investors?
The prospect of negative interest rates is a key driver for the local bond market. When rates are expected to fall, bond prices tend to rise (and yields fall). Bailey’s comments came the same day as the first ever sale of a three-year government bond (gilt) with a negative yield [7]. According to Tradeweb data, the value of UK gilts with negative yields at the end of May reached over £1 trillion, or around 45% of the total market [8].
Negative yields primarily affect fixed income investors who find themselves effectively paying to hold government debt. Historically low bond yields in recent years are one reason why income portfolios have tilted towards equity holdings that provide an alternative source of income through dividends [9]. However, even negative yields don’t necessarily imply losses for a bond investor – 10-year German bunds returned nearly 6% in 2019 [10] despite carrying a negative yield for most of the year as their capital values continued to rise.
Diversifying across the global market is another way of protecting against negative rates in the UK and other developed nations. However, investors should remember that any search for higher returns away from ‘risk-free’ sovereign bonds likely means accepting more risk in their portfolios.
The outlook for the economic recovery and monetary policy remains highly uncertain, but it’s a good time for UK investors to gain a better understanding of how negative interest rates might affect their savings. Even in a negative-rate environment, maintaining a balanced and diversified portfolio will remain the best way to achieve investment goals.
If you would like to discuss your financial situation, please speak to your financial adviser in the first instance.
Past performance is not indicative of future results.
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Sources
- https://www.bankofengland.co.uk/report/2020/monetary-policy-report-financial-stability-report-may-2020
- https://www.reuters.com/article/us-health-coronavirus-britain-boe/bank-of-england-sees-worst-slump-in-300-years-as-coronavirus-bites-idUSKBN22I3BV
- https://uk.reuters.com/article/uk-health-coronavirus-britain-boe/boes-bailey-re-thinking-sub-zero-rates-but-says-reviews-are-mixed-idUKKBN22W23M
- https://www.cityam.com/boes-andrew-bailey-it-would-be-foolish-to-rule-out-negative-interest-rates/
- https://uk.reuters.com/article/us-health-coronavirus-britain-boe/boe-not-remotely-close-to-any-decision-on-negative-rates-haldane-idUKKBN23214U
- https://www.riksbank.se/en-gb/press-and-published/notices-and-press-releases/press-releases/2019/repo-rate-raised-to-zero-per-cent/
- https://www.reuters.com/article/britain-bonds/uk-sells-first-government-bond-with-a-negative-yield-idUSS8N2CU0EP#:~:text=LONDON%2C%20May%2020%20(Reuters),slightly%20less%20than%20they%20lent.
- https://www.reuters.com/article/eurozone-bonds-negative/refile-update-1-more-than-one-trillion-pounds-of-uk-gilts-had-negative-yields-in-may-tradeweb-shows-idUSL8N2DE1XQ
- https://www.asset-intelligence.com/dividends-may20/
- https://www.reuters.com/article/us-eurozone-bonds-returns-graphic/wunderbar-investors-set-for-best-german-bond-returns-in-five-years-idUSKBN1YL2AO
