A bold escape from a negative rate world

Negative interest rate policies around the world have been somewhat perplexing for many investors who have been accustomed to positive yielding risk-free rates of returns.

In the coming weeks, significant change may be in the air, as parts of the world consider moving away from negative rates, likely starting with the Swedish central bank, Riksbank, in mid-December. Such a move may trigger a re-examination of negative interest rate policy throughout the world.

Europe has been the epicentre of negative rates policy since the European Central Bank took rates below zero in 2015. Denmark, Sweden and Switzerland followed the ECB with negative rates policies to help stem excessive currency appreciation of their own currencies against the euro.

At the monetary policy meeting in October 2019, the Riksbank indicated that its policy rate would probably rise to zero per cent in December, even after recognising that risks to slower growth remained and inflation slipped to 1.6 per cent, below its target.

The Riksbank will probably be the first central bank in Europe to exit a negative policy rate, which has fostered political and social discontent –and ever deeper negative rate policy has failed to generate material economic recovery.

Undoubtedly, such a move from the Riksbank will be closely watched by Christine Lagarde, the ECB’s new president. In the early stages in her new role she will likely support outgoing president Mario Draghi’s historic policy, but the ECB’s governing council may take the transition period in leadership to initiate a cultural change in the way the ECB conducts its own monetary policy.

If the ECB cannot get to positive rates by the middle of 2021, then this experiment in negative rates would have been for nothing.

For example, traditionally the ECB does not need to conduct a vote on its policy, but some commentators are suggesting that governing council members may prefer to be heard by voting at every meeting.

So, what does this mean for Ms Lagarde?

Firstly, she will try to renew a sense of cohesion within the ECB’s governing council, which means she will listen to both the benefits and side effects of negative rates and its quantitative easing policy, without prejudice. Secondly, she will most likely conduct a review of monetary policy.

Negative versus zero rates

On that note, let’s recall why the ECB preferred a negative interest rate over a zero rate as a policy tool.

The argument was that negative rates were more forceful and had the potential to heal the economy faster than zero rates. After 5½ years, Europe has happily escaped a deflationary episode, but negative rates and quantitative easing have not spurred the economy out of low inflation and low growth.

The US Federal Reserve remained at zero for seven years. If the ECB cannot get to positive interest rates by the middle of 2021, then this experiment in negative policy rates would have been for nothing, and at the expense of all savers, retirees, and pension funds.

Perhaps a question worth asking during the monetary policy review is whether there is a limit to what a central bank can do to affect cyclical versus structural changes in an economy.

When we live in a highly indebted, low-productivity economy with an ageing population, can economists genuinely forecast growth and inflation to mean revert to historical values during the period when the economy was leveraging up?

A central bank like the ECB has been the only game in town for years, keeping financial conditions easy, hoping for structural reforms and some meaningful fiscal stimulus from the government. It is time that these responsibilities are shared. Extraordinary measures are meant for a crisis, not forever.

The finest line

So what can we expect as we move into 2020?

The delicate balance will be somewhere between maintaining inflation expectations to near 2 per cent – an arbitrary number, qualitatively understood as being far enough from zero not to risk deflation, but not high enough to instigate hyperinflation – and not allowing extraordinary accommodative monetary policy to build inefficient capital allocation and excessive leverage. In a gently sliding economy, that fine line is very thin.

These changes shouldn’t have a great deal of implication for Australian domestic-only fixed income investors, who will likely see further rate cuts in 2020 from the RBA.

However, for Australian investors focused on global bonds, sovereign country allocations will likely be important as some central bank policies are likely to diverge. An active management team with a solid history of geographic asset selection can add significant value for clients in a changing landscape.

Kate Samranvedhya is the deputy chief investment officer of Jamieson Coote Bonds