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From Heresy to Reality: The Weird New World of Negative Interest Rates

Nobody thought that rates could actually go sub-zero. But they have, which is adding previously-unheard-of dimensions to investing and economics. And guess what – rates could go even more negative.

Man cannot fly. Automobiles are a novelty. Telephony is impossible. Of course we laugh, but so it is with shibboleths. They seem so solid until, well, they don't anymore. One of the most recently fallen totems is negative interest. As rates move below zero, which seemed to be an impenetrable barrier, markets and economies are encountering strange behaviours that are important for investors.

They Said It Couldn't Be Done

Some 300 years ago, mathematicians claimed there was no such thing as negative numbers. More recently, most economists said the same about negative interest rates. True, Switzerland flirted with them briefly in 1979, and Japan has skated close to them for the past two decades. But the honest assessment was that, in today's world, paying a bank to keep your cash would be an impossibility. That taboo started toppling after the financial crash of 2008. America's Federal Reserve stated in an internal memo that the 'ideal interest rate' would be -5 percent. Although the Fed went negative only in its thinking, not in reality, Sweden's Central Riksbank actually went negative, cutting its deposit rate in 2009 to -0.25 percent. The sun still came up the next morning, which emboldened central banks in the euro area, Denmark and Switzerland to follow suit. Starting in mid-to-late 2014, all of them were firmly below zero.

Are Negative Rates Working?

As of late 2015, negative rates have been around for more than a year. Despite plentiful criticism, central bankers have stuck to their guns, arguing that their sub-zero lending is the right medicine for still-ailing economies. Meanwhile, they point out that ordinary people would rarely or never encounter negative rates directly. Central banks levy them only on deposits from large institutional and commercial depositors. Moreover, these are limited to sizable deposits, greater than 10 million Swiss francs in Switzerland, for example. Still, there are meaty ramifications for investors, both institutional and individual. As Joe Prendergast, a Credit Suisse Market Analyst, puts it: "Negative rates are a profound event that can and will cause other significant changes."

Mortgage Rates Go up, a Bank Pays to Lend

Some run contrary to expectations. Mortgage interest in Switzerland, for example, has actually risen. According to financial advisor MoneyPark, quotes for a 10-year, fixed-rate home loan have risen by about 0.5-0.75 percent from January to October 2015.
"Banks cannot currently pass on negative deposit interest rates to their household customers," Prendergast explains, "so they need to claw back margins in other areas."
Despite the assurances of central banks, ordinary businesses and people sometimes feel the pinch. Germany's Deutsche Skatbank reportedly is levying a 0.25 percent charge on deposits greater than 500,000 euro. Several Danish banks are charging depositors to hold their money. And in at least one case, a bank is paying a customer to take its loan! According to a report from Danish broadcaster TV 2, Realkredit Danmark is shelling out 7 Danish kroner a month to a woman whom it has lent 5,000 kroner. "It's just amazing," borrower Eva Christiansen told a TV 2 reporter in February 2015, "that I do not have to pay a lot of money in interest."

A Run on Alternative Assets

Professional investors have also been amazed by interest rates, which in their case has driven a flight to alternative assets: hedge funds, private equity, real estate, infrastructure and private debt. Citing data from the Preqin Investor Outlook: Alternative Assets, one Credit Suisse analyst notes the massive, ongoing flows into alternatives, and warns that this presents an underestimated risk of illiquidity. Also concerned is the World Bank which, in a June 2015 Global Economic Prospects note, worried that "bank and non-bank investors may be encouraged by negative rates to take excessive risk […] that contribute to the formation of asset bubbles."

Pension Planning Goes Haywire

Perhaps the biggest casualties of negative rates are the world's pension systems. "Pension funds, and especially public pension funds, are massively underfunded," says John Mauldin of Mauldin Economics, a veteran market-watcher. And he is referring to US funds, which are still operating under slightly-positive interest rates. If negative rates persist much longer in Europe, Credit Suisse's Prendergast contends, major reforms there will be unavoidable. Sub-zero interest, he notes, puts pressure on pension funds that already are struggling with the challenge of decreasing numbers of payers (young people) and increasing numbers of payees (retired people). "Ongoing deficits will force people to work more years and receive lower pensions. This could change the whole nature of retirement."

The Coming End of Cash?

So, should you stick your savings under your bed? Hey, that could be cheaper than paying a bank to keep them. And capacities can be surprisingly large. A bog-standard, one-person mattress from Ikea stuffed with 1,000-Swiss-franc banknotes could store nearly 350 million dollars! Sweet dreams, indeed. Of course, hoarding cash is the opposite of what governments intended with negative rates. So much so, argues Prendergast, that it could be one of the reasons behind some governments' promotion of a cashless society. "How could you impose highly negative rates and really make them stick?" he asks rhetorically. "Easy, just abolish cash."

You Ain't Seen Nothing Yet

Clearly, life below zero has brought some novelties in its wake. And there might be more to come, because in one sense, rates have yet to go truly negative. No kidding – the cost of physically stockpiling cash is normally reckoned at 0.75 percent. Only when rates exceed that, behind a minus sign, will they be negative on a ‘net-net' basis. That -0.75 percent barrier has yet to be broken, Prendergast points out. But, he adds, ongoing pronouncements of central bankers suggest it might be another heresy that is about to become reality.