The Bank of England is being a real tease about negative interest rates. Emissions from various members of the central bank’s policy committee suggest that they aren’t desperate to go negative – but nor are they ruling it out. And now we hear that the head of the Prudential Regulation Authority (the financial watchdog that keeps an eye on the banks) has written to lenders, asking how they’d cope if negative rates did come in.
They wouldn’t be asking if they weren’t at least considering it. So maybe we should be prepared as investors too. With that in mind, what is the point of negative interest rates and what impact would they have?
Central banks keep banging their heads on the same brick wall
The notion of a negative interest rate is not difficult to understand, in theory. When you lend money to someone and the interest rate is positive, you get more money back (assuming they stick to their end of the bargain) than you originally loaned to them. When the interest rate is negative, you get less money back than you originally loaned to them. In other words, you’ve paid them to hang on to your money. So in theory, it’s simple.
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In practice, this notion is outlandish and paradoxical and very hard to wrap your head around. Because when you lend money to someone, you expect to be the one who gets paid interest. You’re the one with the money. They’re the party who needs it. Why would you be the one who pays them?
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Of course, this is the point. If you get paid to borrow money, and you get charged to save money, then we’ll all want to borrow and we won’t want to save. At least, that’s the theory the central banks are following.
How it works in practice – and I’ll simplify this – is that the banks are the ones who get charged to keep money with the central bank. That encourages them (in theory) to try harder to lend it out. They can generally pass this cost onto big depositors, but so far ordinary high street savers – like you and me – have largely been spared (not that we’re getting any interest anyway).
Again, in theory, if we borrow and spend, rather than scrimp and save, then the economy will grow faster, inflation will rise, and everything will be right with the world again. Really, it’s no different to what the central bank instruction manual has been saying for years – lower interest rates means more borrowing and thus more consumption and more activity. As yet, they don’t seem to have lost faith in this mantra, even although it doesn’t seem to be working.
We’ve seen negative interest rates in many parts of the world already. Japan, the eurozone and Switzerland all have negative rates. I think even those of you who rarely take an interest in global macroeconomics will be aware that both the eurozone and Japan are more noted for their distinct lack of inflation, rather than their buoyant, overheating economies.
You can read more about why negative interest rates are a terrible idea from my colleague Merryn, here. But what would this mean for your portfolio?
How negative interest rates would affect your portfolio
As we mentioned, negative interest rates are bad news for banks. That said, there is a great deal of bad news already priced into the banking sector. My own view is that even with negative rates in prospect and the generally dire state of the economy, the UK banking sector is cheap – the main UK-focused banks are trading at less than half their book value.
Of course, we might be waiting a while before they recover. And maybe we will be plunged into a negative rate world, and the banking sector will end up being all but entirely nationalised. However, at current prices, I’d rather be an owner than a seller of the banks.
As for equities in general – if the central bank does push rates into even more negative territory, then it makes sense to assume that it would have roughly the same effect as every other rate cut or money-printing scheme – it’ll boost equities. And in the UK it’d probably be good for the FTSE 100 (which is relatively cheap anyway) because negative rates would push sterling lower, and when the pound goes down, the FTSE 100 tends to go up (assuming the correlation continues to hold). Negative rates would be most likely to push up bond prices (and push down yields) too.
Gold is an obvious asset to hold in a negative interest rate world. Gold has a yield of 0% (or slightly negative once you account for storage costs). But that goes from being a disadvantage in a positive-yield world, to being appealing in a negative-yield world.
Gold would also be a beneficiary if negative rates end up doing what central banks want them to do. That is, if they actually spurred inflation. Gold copes well with inflation, and it copes particularly well with the type of inflation – stagflation – that is terrible for pretty much every other asset class.
Finally, gold also helps to defend against the other downside associated with negative interest rates – the demise of cash. I’ll explain this one in a bit more detail, as it’s important.
Central bankers used to think that the “lower bound” on interest rates was 0%. As we’ve learned, that turned out not to be the case. However, presumably there is a point at which, if you set interest rates too low, people will pull all of their money out of the banking system and stick it under the bed.
The only way around that is to scrap physical cash. Instead, we’d all have bank accounts with the Bank of England. The Bank could then do what it wanted. It could take 5% a year off your savings to encourage you to go out and spend, and you couldn’t do anything about it.
I mean, if it really wanted to create a spending splurge, it could tell us that at the end of the month, our bank account was going to be reset to zero, and any money left in it would simply evaporate. That’s an extreme example, but you get my point.
(And by the way, it’s also another reason why bitcoin might also be a good thing to explore adding to your portfolio. Yes, it’s a digital currency, but it has no central bank, and so no negative interest rates in prospect.)
