Strange Developments Across the Pond

What if someone told you that your savings, instead of making money, actually cost you money? As strange as it may sound, this is what is going on in many European countries today. Instead of paying money on deposits, many central banks are charging fees to hold their big bank customers’ excess deposits. Several high quality companies too have recently issued euro-denominated debt with negative yields. The European Central Bank first cut its rate on deposits to below zero in June of last year. Today, approximately $3.6 trillion or 16% of the world’s government bonds now carry negative yields.

Positive rates of interest have historically made good economic sense. Savers and investors were paid interest in exchange for forgoing the use of their hard earned funds. Borrowers, alternatively, paid interest on funds as long as the expected return on their investments exceeded their cost. But today, this calculus has changed. Many with funds to invest and concerned about the state of the economy are willing to pay for the safety offered by bank deposits. Negative rates also make sense for foreign investors who believe that the interest charges will be offset by future currency appreciation. This has recently been the case in Nordic countries such as Switzerland and Denmark where banking authorities have been enforcing negative interest rates as a way of keeping their strengthening currencies from appreciating against the Euro. Finally, even negative interest rates can look appealing in a yield starved world with few secure options.

European central bankers hope that negative interest rates will help revive economic growth and fight off deflation. The thinking here is that banks, faced with having to pay interest fees on idle deposits, will pick up lending activity. And because central bank rate policy drives the overall level of interest rates, lower rates throughout the economy will discourage saving and encourage consumption. Finally, low relative interest rates tend to depress home currencies and stimulate export growth. While it is too early to get much of a read on the impact of these policies, export growth does appear to be picking up across Europe.

Negative interest rates fly in the face of much economic theory and, as a result, have many concerned. Some economists fear that consumers, when faced with negative rates, will simply withdraw funds from banks reducing liquidity in the financial system. To date, there is little evidence that banks or consumers are withdrawing funds.

More concerning, however, is the idea that negative rates are simply evidence of the inability of standard economic policy tools to deal with a very weak global economy. While we would agree that the unprecedented levels of Quantitative Easing have had a somewhat muted effect, we are optimistic. After years of stagnation, wage growth, historically a primary driver of inflation, has begun to gain ground here in the U.S. (see chart above). And with the national unemployment rate at a 7-year low of 5.5%, we are betting further gains are in store. Stronger incomes should support consumer spending here in the U.S. while the unprecedented fall in the Euro should fuel export growth abroad. These are two steps in the right direction.