The Positives of Negative Interest Rates
Negative interest rates are unbelievable. In fact, in many ways, they were inconceivable until just a few short years ago. Interest rates had a theoretical stopping point at 0% in past financial theory. After all, why would someone lock in a negative return on an investment? Wouldn’t they just hold cash instead? It turns out there may be several reasons why they might. Even more, there are some positives that can come from negative interest rates you may not be thinking of. Here’s two of them:
1. Rates May Go Lower – When interest rates fall, the price of a bond goes up. So, if zero is no longer a stopping point for rates, in theory, they can go even lower. If that happens, these bond returns can look good. There’s a limit to that, at least we think so. At some point, investors may turn to stockpiling physical cash. They don’t right now because of the inherent risks in hoarding. Have you ever misplaced a dollar bill? I’d venture to say yes. Now, what if you had a million of those sitting around? Do you think you might lose a few? I’m sure you’d be extra careful with that amount of cash. I’m also sure there’d be a target on your cash as well for potential thieves. So, there is a cost to cash, either in the form of misplacing it or needing to pay to protect it, but at some negative rate, that cost can make sense.
2. Currency Matters – As of August this year, there were about $17 trillion dollars yielding negative interest rates. That’s massive! If we look at the yield curve in Germany, you can see below a very negative picture. In fact, some weeks after this chart was produced, rates went even lower. So low that every single point of the yield curve, no matter how long you tied up your money, was below zero.
Yet when we sit in the U.S. as investors with Dollars, the picture above changes. We must think of two components of return when it comes to international bonds. One is the yield, which is what you see above. The other is the currency return (positive or negative) that comes from turning Euros back into Dollars. Every day, there is a “cost” to this currency conversion or hedging cost. The main driver of how much it costs to hedge a currency back to a home currency is the difference between short-term rates in each currency. So, in the case of the Euro back to the Dollar, it’s closely linked to what the European Central Bank sets as it’s rate (currently -0.5%) and what the U.S. Federal Reserve sets as the rate (currently 2%). So, if someone was trying to hedge Dollars back to Euros, that’s a losing proposition of about -2.5%. However, if we are going from Euros back to Dollars, you get the other end, +2.5%.
What does that mean? Well, it means for a U.S. investor, the apparent negative yielding German curve transforms into a positive one when you combine rates and currency:
So, a U.S. investor may actually want to buy negative interest rates when you consider the whole picture. It’s counterintuitive at first glance, but as with many aspects of investing, a true understanding requires digging several levels deep.
*Currently used above means as of 9/18/2019.
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Chad spends his day helping BDF deliver on it's promise of helping you enjoy a full life. In addition, Chad leads BDF's Investment Committee which oversees both the strategic and tactical decisions for the firm’s entire client portfolio base. Chad is a frequent speaker and often quoted in publications such as The Wall Street Journal, Forbes, Investment News, Smart Money, ETF Perspectives, and Dow Jones Newswires.