Negative Interest Rates – a Thought Experiment

In recent weeks the Bank of England (BoE) wrote a letter to major UK banks to verify how ready they would be if the Bank of England base rate moved from 0.1% into negative territory.

They stated that for negative rates to be effective, the financial sector must be ready to implement them in a way that doesn’t negatively affect its safety or soundness of firms.

Whilst it’s generally accepted that negative interest rates won’t be entered into, it’s interesting to explore what the consequences would be if they were.

Even prior to the coronavirus pandemic, the UK economy’s growth was comparatively weak, so when restrictions were brought in to address the spread of Covid-19 the Bank of England had to act to help support the economy. They did this by reducing interest rates and via quantitative easing strategies.

Very simply, these policies are designed to help keep money in the economy and to kick-start spending. The intention is to get money flowing out of banks and into the economy in the form of loans and mortgages.

Despite actions taken earlier in the year, the prospect of increasing unemployment and its resultant effect on economic prosperity mean that the Bank of England are having to plan for further stimulus. As I write, the UK base rate is historically low at 0.1%, any further cuts suggest rates may turn negative.

If interest rates are cut to fall below zero, the theory outlined above should still apply to encourage borrowing and discourage saving. However, negative interest rates can result in some bizarre outcomes.

Have negative interest rates worked in the past?

Evidence from negative rates in Europe is mixed but does not really support the argument that they encourage greater lending activity.

Negative rates mean that banks are charged for holding cash reserves with the central bank, rather than being paid. This in turn reduces profit margins and means banks have to look at measures to recoup that cost.

The theory suggests that banks pass on the cost to savers by charging them to hold cash.  However, banks have been reluctant to do this. Some have increased banking fees or charges but others haven’t been able to, which means they have reduced lending, which is contrary to the policy’s intention is to stimulate the economy.

How would negative rates affect my mortgage?

In theory, in this scenario, lenders would actually pay the borrower. In some European countries, mortgages are at sub-zero rates. In practical terms, negative rates have reduced outstanding capital balances which means borrowers repay their mortgage more quickly.

This seems like such a perverse outcome for a lender but a negative return may still be a better return relative to other returns a bank could receive on its capital.

 

Could UK mortgage rates really go negative?

Many believe this is highly unlikely. From a practical perspective, most people in the UK take out Fixed Rate mortgages. Borrowers would need to wait for that Fixed Rate to expire before being able to benefit from negative interest rates, which suggests a negative interest rate policy would need to be around for a prolonged period of time before negative mortgage rates become common place. Anyone with a tracker mortgage may have signed up to terms preventing their rate going negative.

Will I have to pay my bank to hold my cash?

It is possible that the costs of holding cash on deposit increase. In countries that have already implemented negative rates we have tended to see interest rates at zero, but the majority of people have not had to pay the bank!

That said, German savers have experienced negative rates on deposits. However, it’s mainly large institutions and savers with large sums on deposit that have been affected.

Impact on bond markets

Government and corporate bonds are traditionally considered a lower risk asset which provide investors with an income.

They are debt instruments which, on issue, allow governments and large corporations to raise finance to fund their expenditure / investment obligations.#

Debt is issued with a fixed rate of interest paid over a fixed period of time and on maturity investors receive their capital back. The bonds can be traded after issue and the value of that bond is dependent on the strength of the issuer (this determines how safe the capital may be) and the relative value of the income it delivers (this can be influenced by interest rates and expectations for future interest rates).

Interest rate cuts encourage capital values of bonds sold on the secondary market to increase and this reduces the yield (income) that can be achieved by holding this type of asset.

This effectively pushes investors to look for alternative assets to deliver the income they require. Often this means investors take on additional investment risk.

Impact on stock markets?

Lower interest rates increase the relative value of future earnings that companies make which tends to lead to an increase in the value of their shares.

Summary

It is generally accepted that the Bank of England are highly unlikely to reduce interest rates to zero. The risks of negative consequences to key actors within the economy are high and for that reason we may instead see extensions or variations of Quantitative Easing measures.

 

This entry was posted in Financial Planning. Bookmark the permalink. Both comments and trackbacks are currently closed.
  • Twitter

  • Testimonials

    We are both very grateful for the time you spent with us in explaining various options. We certainly feel we now both have a much better understanding of our situation & the decisions which we need to consider moving forward.
    Thank you so much again for your time and brilliant advice.
    It’s lovely for us to have nice friendly advisors like Jonathan and Morven.
    Thanks again for your advice, you have given me the kick I needed to take control and I’m very grateful for that.
    Morven’s guidance about pensions and investments has provided us with excellent returns, even during the recent turbulent financial times. She has been a helpful and friendly advisor for many years and we wouldn’t hesitate to recommend her.
    With great thanks for all your reassuring attention over the last year. It means more to me than I can express in a few words.
    The professionalism of your service continues to give me confidence that we are pursuing the optimum route with our finances. The sound advice you provide is more critical than ever in the current climate.
    I’m really impressed by how responsive you have all been to get this through against such a tight timescale.
    Thank you for your visit today. We enjoyed meeting you and found you to be very thorough and knowledgeable. As a result, we now have a positive outlook concerning the future of our finances
    Just a big thank you for all you have done for our family. We do appreciate it.
Main Menu