In March 2015 we discussed the opportunities and threats posed as $3t of global bonds traded with negative yields. Last week, that figure hit $6t – one third of the total market. Meanwhile, more central banks are talking or enacted NIRP – Negative Interest Rate Policy – raising some awkward questions. It’s tough to build a definitive narrative around the effectiveness and risks of NIRP in the current environment, given the number of fluid factors that could interact with central bank policies. But, evidence suggests that negative rates might only be beneficial only in small doses and it’s increasing hard to ignore the risks that a further prolonged period at or below the zero bound might pose.
First the good news…
EY ITEM Club’s latest report on UK financial services shows a sector in improving health. In 2015, underlying economic fundamentals were good enough to support a return to growth across the board for the first time in a long time. Assets under management (AUMs) grew to a record high of £906b, lending to businesses grew for the first time since 2009, and insurers didn’t fare too badly – despite some negative surprises.
The year ahead has potential. UK economic growth is projected to pick up to 2.6% in 2016, from 2015’s slightly disappointing 2.2% rate. Consumer spending is expected to continue growing at a strong rate, with sustained low inflation supporting a rise in real incomes. Confidence among households and firms should remain high and the housing market remains stable. Nevertheless, risks are building that could significantly alter the landscape for the UK financial services sector and beyond. There are some 40 major financial services regulatory reforms driven by the EU that would be affected by BREXIT. There is obvious distress in the leveraged oil & gas sector, growing concern for a number of emerging economies and the potential for global slowdown. And, not unrelated to these factors, the difficulties of a low interest rate world are being amplified as negative interest rates deepen and spread.
Welcome to NIRP world
In last few weeks there has been a decided shift in rhetoric around NIRP (Negative Interest Rate Policy) to the point where it’s starting to sound mainstream. Arguably it already is. Two of our four major central banks – the ECB and Bank of Japan – have negative rates, with the ECB rumoured to be considering a further cut in March. Janet Yellen reported that the Fed has investigated negative interest rates in her recent congressional hearing. The Bank of England seems unlikely to follow suit, although UK interest rates now seem set to stay at 0.5% for the rest of 2016. Outside of the ‘big-four’, Denmark, Switzerland and Sweden have negative interest rates, with the Riksbank surprising everyone with a further large cut last week.
We recently crossed the point where $6tn of global bonds yielded below zero. The Japanese 10Y bond yield fell below zero for the first time. The German 10-year Bund yield hit 0.16% – now around 0.25%. It’s a chaotic time and early in the narrative, but such extreme moves suggests it’s worth looking again at the risks – especially for under pressure banks.
Banking on stimulus
As ever, we have the issue of concurrence and causation. Markets – and bank equity and bond prices – have obviously taken a tumble in 2016. But are central banks responding to or causing the problem? Those who say it’s the source of market stress, point to the potential to damage banks’ margins and thus the progress of our fragile recovery – most notably, PIMCO’s Scott Mather. The defenders point to the potential of NIRP to stimulate demand, thus creating a net positive for banks profits. In retail banking, where negative rates are obviously problematic, Martin Sanbu, the FT’s lead economics writer, argues that negative rates could start on the margin, i.e. on the top portion of people’s balances and any new deposits. He believes this will create a “strong incentive for banks to lend and for consumers to burn their money on spending.”
Nevertheless, almost without exception, banks in NIRP areas have decided against (or felt unable) to follow this course of action thus far. That hasn’t automatically led to a credit squeeze. JP Morgan’s research shows that “the introduction of modestly negative policy rates appears to have had a positive impact on credit creation”. But, you can have too much of a good thing, since it also found that there “is no evidence that very negative policy rates helped credit creation further.” Indeed they found that “credit creation to the real economy deteriorated in Denmark during 2015 vs the previous year.” Their evidence also shows that in the case of both Danish and Swiss banks, negative rates reduce bank profitability via an erosion of net interest income. Negative interest rates didn’t just hit their central bank reserves, which can be limited by a tiered scheme, it also reduced income from a number of other sources, such as security holdings as government bond yields turned negative.
It is hard to discount these risks or assume that they will necessarily be netted off by stimulus positives. So much depends on the overall economic backdrop, which arguably isn’t as promising or stable as 2015. This still feels like an income statement issue not a budding balance sheet crisis, given the monumental support available now across the system compared to 2008. The recent recovery in bank shares would suggest some acknowledgment of this; but some caution is nevertheless justified by this and other economic and political headwinds. This will be a difficult year for banks to navigate.
And just on the debt…
Before we leave NIRP, we need to come back again to what this says about where we are in the cycle. NIRP is part of the policy response that allows us co-exist with, rather than reduce or restructure the world’s ever growing debt pile. Last June, The Bank for International Settlements expressed its concern that by going ever lower, central banks were in danger of entrenching “dependence on the very debt-fuelled growth model that lay at the root of the crisis”. NIRP also feels worrying like central banks at least getting towards the end of the road – with little chance of creating much more tarmac before the next downturn. It’s a tough call, because central banks have become the last bastion against slowdown, but it still feels like we’ve not really faced up to our debt problem.
VoxEU has published an ebook this week, containing some interesting thoughts on how to fix the Eurozone. If you like your counterfactual history, I recommend “How the Euro Crisis was successfully resolved”. Spoiler, in this version of history, Greece has a 50% debt haircut in 2010…
Saudi Arabia has agreed with Russia to freeze oil output if they are joined by other large producers. The oil price was moving up on hopes of a production cut, fell as it became clear that this was off the table and drifted up again on hopes of Iranian co-operation. Given that demand seems unlikely to race up in 2016, this pretty much leaves the status quo and it will take more to push prices much higher.
The realities of oil the in $30s is really starting to bite. Oil majors investment has fallen by almost $400bn. The dividends of oil companies – so long protected – may be at risk if prices do not start to recover by the second half of the year, according to Fitch Ratings. Oil producing nations are seeing their credit ratings cut – to junk in Bahrain’s case. We’re seeing more oil companies engaging in small disposals, selling off the family silver to keep going in the hope that things will improve soon. But it looks like they’ll need more radical action to stay the course.
The chart left shows the oil price adjusted for US inflation. The median price since 1987 is $38/barrel coincidentally not far off the current adjusted price. This doesn’t take into account depleted reserves and the myriad of other factors that go into making the price of a barrel of oil, which might take this figure closer to $50…still it gives some insight into how the super-cycle might have distorted our perceptions of what oil prices can or should be.