OECD: Low and negative interest rates threaten financial stability
In its latest report, the OECD warned markets about the consequences of « exceptionally low interest rates, which distort the functioning of capital markets and increase risks across the financial system as a whole […] Governments are relying too heavily on monetary policy. » How can low and negative interest rates pose a threat to financial stability?
In response to the financial crisis, central banks in developed countries pursued ultra-expansionary policies by drastically lowering interest rates and buying up government bonds on a massive scale. In doing so, they prevented the global banking system from collapsing and the global economy from sliding into depression.However, the actions of central banks have not been able to restore growth and inflation to pre-crisis levels. For example, companies did not take sufficient advantage of low interest rates to invest in the real economy, and mainly used this money to buy back their own shares[1]. The global economy now seems to be caught in a « low growth trap[2], » in which interest rates are extremely low or even negative.
According to the OECD, more than 35% of developed countries’ sovereign debt has a yield to maturity of less than 0% (approximately $10 trillion). A negative interest rate on a sovereign bond simply means that the investor has to pay the issuer (the government) to hold its debt. Similarly, in a negative deposit rate system, banks are charged for excess liquidity held with the central bank. One of the objectives is to stimulate economic growth and increase inflation via the exchange rate channel, and in particular to encourage banks to lend to consumers and businesses.
However, central banks[4] are beginning to question the marginal effectiveness of quantitative easing[5] and the medium-term implications of negative interest rates on the financial industry[6]. Indeed, a low interest rate environment erodes banks’ margins[7] and increases the value of insurers’ liabilities[8] (balance sheet liabilities). Thus, the benefits of negative interest rate policy could fade in the medium term, as banks will likely tend to reduce their credit offerings if they do not generate sufficient margins.
Furthermore, the low interest rate environment is pushing investors to take more and more risks in order to obtain higher returns. To do so, investors are buying up riskier assets such as emerging market bonds andhigh-yield bonds, further distorting the prices of these asset classes. This huge disconnect between bond values and fundamentals is mainly based on market participants’ confidence in the ability of central banks to intervene in the event of a shock. As a result, markets tend to overreact to news, especially when they fear that central banks are running out of ammunition. All of these factors « increase investors’ vulnerability in the event of a sharp correction in asset prices, » as highlighted by the OECD.
Yield spread between Portugal and Germany (2-year maturity)
Take the example of Portuguese sovereign bonds, which experienced exceptional volatility at the beginning of the year (see chart above). In February, 2-year and 10-year rates rose within a few days from 0.34% to 1.22% and from 2.86% to 4.09%, respectively[12].In a single trading session, the spread between the minimum and maximum short-term rates exceeded 70 basis points, meaning that investors expect the issuer to default, which is completely irrational. Of course, Portugal’s macroeconomic outlook has darkened recently, but the market’s perception was greatly exaggerated. Concerns about the DBRS rating agency’s rating and market risk aversion both weighed on Portuguese bonds. However, in just a few days, the bonds recovered some of their losses.
Investors are not immune to further turbulence in the financial markets, so caution is the order of the day. It would be inappropriate to blame central banks for this « mess. » Indeed, central banks are trying in vain to fulfill their mandate of price stability, while governments remain fairly passive in the face of structural problems that monetary policy alone cannot solve.
Notes:
[1]« Share buybacks are used by listed companies to increase share prices by reducing the total number of shares available on the market, thereby increasing earnings per share. Since part of executives’ compensation is in the form of shares, these buybacks increase their salaries without benefiting workers, thereby amplifying income inequality. University of Michiganhttp://michiganross.umich.edu/rtia-articles/how-corporate-america-can-curb-income-inequality-and-make-more-money-too
[2]Global economy stuck in low-growth trap: Policymakers need to act to keep promises,OECD Economic Outlook
[3]Source: JPMorgan Negative Yield Index Monitor, October 2016
[4]https://www.ecb.europa.eu/press/key/date/2016/html/sp160728.en.html
[5]Notably on the marginal effectiveness of the program: some economists believe that increasing the size of the bond-buying program would not have as significant an impact on the economy as it did a few years ago
[6] The sharp fall in nominal rates is the result of several structural factors, such as the aging population and low productivity gains, and is not solely a consequence of the monetary policy pursued by central banks in recent years.
[7]Put simply, banks generate profits by borrowing short-term funds (bank deposits) while lending long-term funds (e.g., through mortgage loans). With yield curves extremely flat (i.e., the spread between short- and long-term rates is very small, with the 10-year/2-year spread at around 0.60% compared to an average of 1.20% since 1993), banks are finding it increasingly difficult to be profitable in this sector
[8]Insurers invest in long-term bonds in order to cover their long-term commitments to policyholders. It is therefore becoming increasingly difficult for insurers to honor their future commitments when rates have fallen significantly.
[9] According to Bill Gross, « Capitalism cannot function properly with rates close to zero or negative. »
[10] Banks, insurers, pension funds, asset management companies
[11]By buying more and more higher-yielding bonds, investors are making them increasingly expensive without any improvement in the issuer’s fundamentals.
[12] The price of 10-year bonds fell by around 11.3% from 100.068 to 89.908 (January 29, 2016-February 11, 2016).
[13]DBRS is the only rating agency to assign Portugal « investment grade » status, making the country eligible for the ECB’s debt buyback program. Thus, if DBRS decides to downgrade Portugal to « speculative grade, » Portuguese bonds will no longer be eligible for the ECB’s QE program.
[14]Portuguese bonds are perceived as one of the riskiest investments in the eurozone sovereign universe. This means that when markets perceive high risk, investors tend to reduce their exposure to risky assets (Portugal) in favor of safe assets (Germany).
Source:
http://www.marketwatch.com/story/oecd-negative-rates-threaten-financial-stability-2016-09-21
http://www.wsj.com/articles/negative-rates-and-insurers-be-afraid-1457030114
http://www.bloomberg.com/news/videos/2016-09-22/what-is-the-future-for-qe-and-the-boj
http://www.riksbank.se/Documents/Rapporter/PPR/2016/160421/rap_ppr_ruta1_160421_eng.pdf
http://www.bis.org/publ/work435.pdf
English version:
OECD: Low and negative rates threaten financial stability
In its latest report, the OECD warned that“exceptionally low interest rates are distorting financial markets and raising risks across the financial system [ …] monetary policy is becoming over-burdened.” How could low and negative rates pose a threat to financial stability?
In response to the global financial crisis, central banks from developed countries launched ultra-expansionary policies dragging down interest rates and printing money to buy sovereign bonds. They succeeded in preventing a complete collapse of the banking system and the global economy from falling into depression. However, monetary easing has probably failed to prop up growth and inflation at a decent rate. For instance, corporations did not fully benefit from cheap money provided by central banks to invest in the real economy, but instead bought back their equity stocks. Now, the global economy seems stuck in a « low growth trap » where interest rates are extraordinarily low or even negative.
According to the OECD, more than 35% of sovereign debt from developed countries is now trading below 0% (around USD 10 trillion[17]). Negative rates on government bonds mean that investors have to compensate sovereign debtors for holding their debt. Similarly, a negative deposit rate implies that banks have to pay to park their money at the central bank. Negative interest rates can be considered as taxes on savers. The aim is to stimulate economic growth and raise inflation by encouraging banks to lend money instead of keeping it at the central bank.
However, the effectiveness of quantitative easing going forward is becoming increasingly questionable, while the adverse implications of negative interest rates on the financial services industry are widely debated by central bankers. Low and negative yield environments constrain banks’ margins, while insurers’ liabilities increase. In this context, banks will refrain from lending if they do not generate enough profit on their retail activity. That is the reason why the Bank of Japan recently decided to change its monetary policy (see BSI article) in order to avoid excessive flattening of the yield curve as it negatively affects earnings of financial institutions. These side effects from negative interest rates may weaken the net profitability of financial and banking institutions and so the whole financial industry[23], particularly if interest rates remain negative for a long time.
Against this backdrop, investors[24] are taking more and more risks in search of higher returns. They are investing in emerging markets, high-yield companies, and other risky assets in order to improve their returns, further distorting financial market prices[25].This huge difference between asset valuation and fundamentals is based on faith in central banks’ ability to mitigate any adverse shock. As a result, markets tend to overreact to any news, especially when they perceive that central banks are running out of ammunition. All of these factors tend to increase « the vulnerability of investors to a sharp correction in asset prices, »as highlighted by the OECD.
2-Year Portugal-Germany spread
For instance, Portuguese sovereign bonds have been subject to exceptional volatility (see chart below). In February, 2-year and 10-year government bond yields soared from 0.34% to 1.22% and from 2.86% to 4.09% respectively. These are huge movements for fixed income markets[26]. Intraday moves were also spectacular, with a peak-to-trough of nearly +70bp, meaning that markets were pricing in a default, which is completely irrational. Of course, the macro picture has deteriorated in Portugal, but probably much less than the market perceives. Concerns over the DBRS rating and the risk-off mood have exacerbated pressure on Portuguese bonds, but a few days later, bonds had already erased their losses.
That kind of market turmoil may recur in the future, which is why investors should remain very cautious. One should not blame central bankers for that mess. At least they are trying to fulfill their mandate, while politicians have done nothing to deal with structural issues that monetary policy cannot fix.
Source:
http://www.marketwatch.com/story/oecd-negative-rates-threaten-financial-stability-2016-09-21
http://www.wsj.com/articles/negative-rates-and-insurers-be-afraid-1457030114
http://www.bloomberg.com/news/videos/2016-09-22/what-is-the-future-for-qe-and-the-boj
http://www.riksbank.se/Documents/Rapporter/PPR/2016/160421/rap_ppr_ruta1_160421_eng.pdf
Note
1]“These are used by public companies to boost their stock prices by reducing the total number of shares, which in turn increases earnings per share. However, because this enhances stock-based executive compensation without benefiting workers, stock buybacks amplify income inequality. » University of Michigan http://michiganross.umich.edu/rtia-articles/how-corporate-america-can-curb-income-inequality-and-make-more-money-too
2]Global economy stuck in low-growth trap: Policymakers need to act to keep promises, OECD Economic Outlook
3]Source: JPMorgan Negative Yield Index Monitor, October 2016
4]Some economists think that more stimulus, more QE is likely to have much less impact than a few years ago
5]The sharp decrease in yields is a result of several structural factors, such as aging population, lower productivity growth, and not solely due to central bank intervention
6]https://www.ecb.europa.eu/press/key/date/2016/html/sp160728.en.html
7]Banks typically make money by borrowing short-term money through deposits (bank accounts) while lending in the long term (loans to buy a house). Nowadays, yield curves are extremely flat (the differential between long- and short-term rates is very small, with the 10-year/2-year differential at around 60 basis points vs. 120 basis points on average since 1993), making it harder for banks to be profitable.
8]Insurers invest in long-dated bonds in order to match long-term promises to policyholders. When yields go down, it becomes harder to honor future promises.
9]According to Bill Gross, « Capitalism, almost commonsensically, cannot function well at the zero bound or with a minus. »
10]Banks, insurers, pension funds, and asset managers
11]Indeed, by investing more and more in higher yielding bonds, investors make them more and more expensive, further distorting asset prices from fundamentals.
12]The 10-year bond price tumbled by around 11.3% from 100.068 to 89.908 (January 29, 2016-February 11, 2016).
13]70 basis points equals to 0.70%, meaning yields rose from 0% to 0.70%.
14]DBRS is the only rating agency assigning an investment grade status for Portugal, making it eligible for the ECB’s QE program. If DBRS decides to downgrade the country’s notch, Portuguese bonds will lose the support of the ECB.
15]Portuguese bonds are perceived as one of the most risky investments within the Eurozone sovereign universe. This means that when markets perceive risk as high, investors tend to switch from higher risk investments (Portugal) to lower risk investments (Germany).
