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Negative rates: a potentially counter –productive and stress inducing measure


Many negative factors continue to weigh down the financial markets: the economic slowdown, which has been palpable for several quarters, has worsened, and has caught a far too optimistic consensus off guard.

The central banks have been unsuccessful in easing these pressures. Worse yet, they are adding to it, with scant leeway (the Fed) and policies that are ineffective at best (Japan) and potentially counter-productive at worst (BoJ and ECB) – including sending long-term and short-term rates into negative territory, which is maintaining rather than combating the deflationary climate. The situation is also eroding banks’ profitability and creating frequently meaningless valuations. Luckily, the ECB has decided to use a full set of instruments (TLTRO, QE extension to corporate bonds…), which is dilution of the negative impacts of negative rates. All in all, we nevertheless understand the distrust to interest rates cuts.

The factors pushing down interest rates are many and solid. The whole range of interest rates (natural rate, equilibrium rate, key rates, nominal rates, real rates, discount rates…) declined. As a consequence, business models of banks, insurers, asset managers, bond issuers, central banks have been impacted. These changes are significant and certainly long-lasting. In sum, in some respects, negative rates are reshaping the economic and financial environment.



Of course it is easy to understand why the ECB wanted to test the level of rates below which the banks stop holding their surplus cash at the central bank, but the question is whether it is really worth the trouble, given the risks of such a policy. At the end, the ECB will probably not test this level, should we understand correctly the Q&A session of Mr. Draghi. What is needed is not so much to keep lowering rates and send the entire range of rates into negative territory (as in Japan right now), but to hold rates down. If the banks have liquidities, it is precisely because the ECB is injecting them en masse, and the drop in deposit rates is penalising banks’ profitability (all banks, whether in the core zone or the periphery), just when they are being shaken up by the markets and even being asked to lend more to the economy. This is a paradox, an unmistakably counter-productive one. In all, the continued decline in rates is feeding into fears of deflation more than it is fighting them. That is the reason why this measure cannot be adopted alone. The ECB therefore decided to implement a full set of different measures on March 10. It delivered above the most optimistic expectations:

  • The interest rate on the main refinancing operations of the Eurosystem will be decreased by 5 basis points to 0.00%, starting from the operation to be settled on 16 March 2016.
  • The interest rate on the marginal lending facility will be decreased by 5 basis points to 0.25%, with effect from 16 March 2016.
  • The interest rate on the deposit facility will be decreased by 10 basis points to -0.40%, with effect from 16 March. 
  • The monthly purchases under the asset purchase programme will be expanded to €80 billion starting in April. 
  • Investment grade euro-denominated bonds issued by non-bank corporations established in the euro area will be included in the list of assets that are eligible for regular purchases
  • A new series of four targeted longer-term refinancing operation (TLTROII), each with a maturity of four years, will be launched, starting in June 2016. Borrowing conditions in these operations can be as low as the interest rate on the deposit facility. 

Financial markets were enthusiastic this time, at least immediately following the announcement, because these decisions are supporting low rates, low yields, peripheral spreads, corporate bonds spreads and banks. Even if these measures reflect (large) underlying problems, it is impossible to neglect the potential positive impacts on both bonds and equities…
Last November, we were – already – writing that it wouldn’t be long before the decline in the ECB’s deposit rates into even more negative territory would have negative effects, given the impact of such a measure. It is helpful to have another look into the reasoning behind this.

1. Why are interest rates so low ? 

When we talk about interest rates, we can distinguish between different types: market rates, administered rates, theoretical rates …

  • Equilibrium rate: the interest in line with fundamentals,
  • Market rate at which transactions take place),
  • Key rate: the central banks’ rates,
  • Short term rates and bond yields
  • Natural rate: the interest rates that balance savings and investment when growth is at its potential,
  • Neutral rate: at the potential growth rate, the neutral nominal natural rate is equal to the neutral real rate, plus the central bank’s inflation target,
  • Nominal rate: the rate at which a contract is set,
  • Real rate: the nominal rate minus inflation,
  • Discount rate: the interest used, to name a few, to value assets… What is remarkable in the current situation is that all of these rates have declined sharply, for cyclical reasons, for structural reasons, and for reasons associated with central banks’ strategies...

The “major” structural factors behind this include:

  • The shrinking working-age population and/or the drop in activity rates. This is a reality in most advanced countries and in China as well, an old before being rich country;
  • The slowdown in the rate of technical progress, which is reducing productivity gains. This is, with demography, a topic usually mentioned by the supporters of the secular stagnation thematic;
  • A massive increase in inequality which represent a burden on potential growth (a theme developed in particular by Robert Gordon);
  • The decline or the stagnation of real disposable income (role of wage policies and taxation);
  • The impact of the debt burden. The excess of credit had boosted growth artificially in lots of countries (United States, Spain amongst others…) until the 2008 financial crisis. Widespread deleveraging that followed has dragged down growth, while economic policies hampered by debts, must still support indebted entities, especially governments, and can no longer counter the economic cycles. In other words, debt is keeping the natural interest rate very low. Here, we also come across the theme of the great stagnation.

The macroeconomic stability of such a regime requires low interest rates, and this should last for a while, because these changes are more structural than cyclical. Debt accumulation is another factor keeping rates at low levels and pleading against any interest rate and bond yields increases. Among the cyclical factors (some of which may be considered in certain respects to be structural and sustainable), we cite:

  • The impact of the 2008 financial crisis: this was a global event and caused a widespread collapse in the natural rate and the equilibrium rate:
  • The decline in central banks key rates, from the 2008 financial crisis until now, and the maintenance of rats at very low levels. Central banks have difficulties to exit such an accommodative stance, and the United States are certainly the best example;
  • The implementation of unconventional asset purchasing programmes and forward guidance, which have anchored (all) interest rates, term premiums and bond yields at low levels;
  • Declines in (short-term and long-term) inflation expectations. This is a major difficulty for central banks because these expectations are no longer anchored to the central bank’s target.
  • The increase in risk aversion, which is inevitably increasing precautionary savings (some of which are now even being held in assets at negative rates!) and reducing investment, one of the major aspects that are lacking in the current economic recovery;

2. Negative rates and business models

Short rates and bond yields, even some long term yields (in Japan, the 10Yr bond at present) are in negative territory. It is rather difficult to say whether the economies and financial markets can remain in a negative-rate world for long. However, what is certain is that it will lead to radical changes in the business models, even if the situation is only temporary (a few years). 

  • With regard to money-market funds, Japan’s case is emblematic. The first phase of declining rates (in the 1990s) sharply reduced the size of these funds which, at the time, were the largest in the world. It seems that the transition into negative rates will be the coup de grace.
  • One can identify lots of consequences on flow / negative interest rates on asset management activities: long term expected returns, valuation models, the role of bonds in portfolio construction, the concept of riskfree asset, the range of products and funds, cost structures have all to be revisited, while more efficient benchmarks have to be promoted and new strategies have to be implemented … (please refer to our forthcoming Discussion Paper « Low rates / negative rates, secular stagnation … Impact on asset management activites », forthcoming (2016)). All asset management activities are impacted.
  • The findings are also concerning for life insurance companies. Negative rates, and even rates close to zero, are a threat to the sector’s solvency and stability, as was demonstrated by a recent study by Moody’s (European Insurers Face Credit-Negative QE Program, January 2015). The sector’s vulnerability is all the more pronounced when the duration gap between assets and liabilities is greater (a large gap increases reinvestment risk) and a substantial portion of policies (on the liabilities side) were negotiated at guaranteed rates. According to Moody’s, in late 2012, the largest duration gap was in Germany. At 11 years (including health insurance), it was twice that of France or the Netherlands. It was also in Germany that greatest number of policies at guaranteed rates were negotiated (more than 92% of policies, compared to 60% in the Netherlands, 79% in Italy and 84% in France), and at the highest rates (between 3% and 3.5% in Germany, between 2% and 3% in Italy, around 1% in France and at adjustable rates in Spain). As it was the case in Japan, one can expect drastic revision in policies at guaranteed rates, and in interest rates.
  • For the banks, we must admit that the decline in rates was initially favourable. Banks were instantly able to benefit from very low funding costs and, in particular, with no relation to their actual risk. Some banks did have difficulty refinancing on the interbank market and all banks saw their share prices collapse but, whether in the United States, Japan or Europe, unconventional policies initially improved banks’ profitability. The reason for this is simple: QE caused long rates to plunge and, deposit duration is by construction shorter than that of the assets the banks have in their portfolios. How is it possible to consider that abundant liquidity and ultra low interest rates have not offered banks the capacity to delay balance sheet cleaning? This situation could not last: with declining rates and the flattening of the yield curve, the interest margin was literally eliminated, and profitability declined. In other words, the interest rate gap between (short) liabilities and long (assets) virtually disappeared. We should also not ignore the uncertainty surrounding the behaviour of investors. Banks have long modelled this behaviour, which is essential for the retail banking business. However, it seems clear that this behaviour can only change in light of negative rates, a situation that is very different from a low-rate environment. Accepting that one will lose money by entrusting it to a bank is not the same as accepting a low but secure return. How can this assumedly unknown behaviour, given that it relates to an unprecedented environment, be modelled?
  • If we are to believe the comments, the central banks must shoulder a substantial portion of the responsibility for the advent of this situation. However, we have seen above that there are other major factors that have pushed rates down and it would be unfair to place the entire blame at the doors of the central banks. In any event, central banks must also adapt, in particular in terms of managing their reserves. We have known for some time that it is the “yield – risk – liquidity” triad that dominates their decisions. We also know that, in the decreasing order of importance to which central banks have admitted in various surveys, we should really say “security – liquidity – yield”. In other words, the comments on the bubbles that may have been created by the QE programmes have somewhat disrupted the management of their priorities. Liquidity is impacted by the vast purchasing programmes of central banks … while return is impacted by the very low level or interest rates and bond yields. Negative rates represent, of course one the major stakes for foreign exchange reserves management entities.
  • For government issuers, there is a paradoxical aspect to the situation. The weak term premium (it is at its lowest level since the 1960s in the United States) simply means that investors are no longer compensated for the interest rate risks they incur. In contrast, issuers, including governments, are rewarded when they go into debt. Instead of paying interest, they receive compensation. In other words, “rates that are negative or close to zero equate to imposing a savings tax and a debt accumulation subsidy” (Aglietta – Valla, 2016), which does not really encourage keeping debt under control. Put simply, governments are funding themselves at very low, even negative, rates and the ECB is purchasing a significant portion of these issues (it is purchasing more than twice the net issues of European governments). A kind of perpetual motion machine, but not very stable. The situation is similar to the banks’ one: maintaining rates and yields at low level is not a strong incentive for government issuers to become more rigorous.

3. Negative rate! immediate inconveniences, uncertain benefits

As mentioned above, there are numerous factors maintaining interest rates and bond yields at low levels, and this situation has major impacts on business models. These impacts are amplified and distorted further due to negative interest rates. Low rates and negative rates create very different environments. Pushing interest rates into negative territory as Japan, Eurozone, Denmark and Switzerland do has major – and negative – consequences. What to say about ECB?


COMMENT #1 :  Additional rate cuts are unnecessary. Access to financing has improved considerably in two years, more so since the implementation of the QE programme, which has anchored interest rates at a low level for a long time, which is already a satisfactory result in itself. Already, in mid-2015, the ECB’s surveys show that the low point had been reached, while the primary corporate issuance market was growing fast: more than 200 new issuers on the high-yield segment, and a market that had doubled in size in the space of three years. Long-term rates were already extremely low, and, most importantly, tightly pegged to short-term rates. What is needed is not so much to keep lowering rates and send the entire range of rates into negative territory (as in Japan right now), but to hold rates down. The QE purchasing programmes are probably the right tool for the job. 
In 2016, net issuances will be negative, once the ECB’s purchases have been taken into account. For the central government alone, excluding the March 10 ECB’s decisions, they will be -€139 bn for Germany, -€45 bn for France, -€31 bn for Spain, -€41 bn for Italy, -€24 bn for the Netherlands, etc. Who is to say there will be any increase in long-term rates in the Eurozone, in that environment?

COMMENT #2A decline in bank deposits with the ECB does not guarantee an additional increase in bank loans to businesses in the most disadvantaged zones. To put it plainly, if German banks withdraw their deposits from the ECB, are they going to lend to companies in southern Europe? Obviously, the answer is no. A required condition is not the same as a sufficient condition.

COMMENT #3 : If the banks do have liquidities, it is precisely because the ECB is injecting them in quantity: don’t confuse causes with consequences. We were well aware that in January 2015, when announcing its QE, the ECB bemoaned the fact that commercial banks were depositing their cash in its accounts, and that it would rather have seen those funds paid “into the real economy.” But those funds kept on growing at the same pace as the ECB’s asset-buying programme: then at €100 bn, deposits with the ECB are currently around €500 bn, and the ECB is partly responsible. Instead of buying government bonds (with duration risk, asymmetric risk and negative yield), banks prefer deposit cash to the ECB, overnight, riskless, negative return and without any asymmetric risk. How to blame them?

COMMENT #4 : The drop in deposit rates is dragging down banks’ profitability (all banks, whether in the core zone or the periphery) just when they are being shaken up by the markets and even being asked to give the economy more credit. This is a paradox, an unmistakably counterproductive one.

COMMENT #5 : The ECB must fight any threat to price stability (upor downward). It is very clear that currently, deflation, not inflation, is still the threat. But unlike the situation two or three years ago (or the one in Japan in the 1990s-2000s), deflationary pressures are no longer coming from the zone, but from outside it: oil prices; declining global trade; sagging globalisation; and the slowdown in global growth, all of the emerging countries, and US growth, and so on. We are seeing a close link between inflation expectations and oil prices. Except for buying oil, which is, of course, light years away from its mandate (!), the ECB cannot do anything about it!

COMMENT #6 : The continued decline in rates is feeding into fears of deflation more than it is fighting them. In the current environment, lowering rates into negative territory is not the answer. And the ECB cannot do everything itself. Without a doubt, the answer is more fiscal (and budgetary) than monetary. Everyone expects everything of the ECB, and that is neither normal, nor legitimate, nor rational. It undoubtedly reflects the lack of leeway elsewhere and/or the lack of unity within the eurozone. No matter how you look at things, there is nothing reassuring about it.

COMMENT #7 : The ECB cannot post a target for the euro’s external value (that is not its mandate, as Mr Draghi keeps repeating every time he is asked a question about the euro), but we know how helpful a decline in the euro would be (corporate profits, restored margins, etc.). The renewed vigour of the European currency in 2015 is more a result of what has happened with emerging currencies, and then what happened in terms of the repricing of US growth and the Fed’s monetary policy expectations. And there has undoubtedly been another factor: the Eurozone is ultimately the only zone/ country without an explicit foreign exchange policy. In other words, the euro adjusts to others’ policies.

COMMENT #8 : An excessive cut in rates inevitably creates abnormal, excessive valuations. In valuation models, interest rates are a component of the denominators and, mechanically, the decline in rates, which reduces the cost of capital, and results in higher valuations. In other words, it is normal to have high valuations in a low-rate environment... without necessarily ending up with bubbles. But it is all a question of proportion or... disproportion. With negative rates, “traditional” valuations no longer have much meaning, and there is nothing reassuring about moving into unfamiliar territory either. Should the ECB really heighten these worries, or indeed add to them?

COMMENT #9 : By sending short-term and long-term interest rates into negative territory, the ECB is also sending negative messages to the financial markets. And this comes at a time when growth has progressed (more solid, driven by domestic demand, not public spending), inflation is under control, and the factors pushing it lower are more external than internal. The central banks’ credibility is in question. Until last December, the ECB had been flawless; we can clearly see that confidence in all of the central banks has dipped, and neither the ECB, the Fed, the BoE, the PBoC nor the BoJ has a blank cheque from the financial markets.

COMMENT #10While the advantages of negative rates are, at best, uncertain, and in reality non-existent, the negative fallout is a given. Above, we have covered the messages sent by the central banks, the problems of bank profitability, deposits with the ECB, maintaining the deflation situation, and excessive valuation of risky assets. We can add that negative rates can only provoke withdrawals of monetary funds (a negative impact for asset management) toward the banks’ deposits, which represents an additional drop in the banks’ profitability. A game that is not even or positive, but negative...


All in all, we clearly see the rising mistrust of the rate cuts, given the levels already reached. Factors dragging down interest rates and bond yields are many, and strong. Lower market rates, natural interest rates, key rates, nominal rates, real rates, equilibrium rates, discount rates … are nothing but a surprise. This situation has major implications for asset management, insurance companies, central banks, government issuers’ business models. The implications seem sustainable at this stage, and to some extend, dangerous: negative rates represent a tax on savings and a subsidy on debt accumulation, which is exactly the opposite of what should be promoted. In sum, negative rates are reshaping the economic and financial environment, not for the best.
















Equilibrium rates, nominal rates, real rates, natural rates, neutral rates, key rates, market rates... all interest rates have fallen sharply











Low rates and secular stagnation: uncompromising logic



Unconventional asset purchasing programmes and forward guidance have anchored (all) interest rates, term premiums and bond yields at low levels



It is rather difficult to say whether the economies and financial markets can remain in a negativerate world for long



Negative rates, and even rates close to zero, are a threat to the sector’s solvency and stability



Negative rates and life insurance companies: the weight of guaranteed-rate policies and duration gaps














Negative rates and retail banking: remodelling investors’ behaviour




Negative rates represent one the major stakes
for foreign exchange reserves management entities



Negative rates? A savings tax
and a debt accumulation subsidy









Additional rate cuts are unnecessary




Who is to say there will be any increase in rates, with regard to the QE’s impact?



If the banks do have liquidities, it is precisely because the ECB is injecting them in quantity


The drop in deposit rates is dragging down all banks’ profitability


The continued decline in rates is feeding into fears of deflation more than it is fighting them



Who is managing the euro in the Eurozone? Answer: no one


Negative rates... and infinite values? What is this all supposed to mean?


Can we send a worse message than negative rates? Hard to say, in the current environment


Publication finalised on 11 March 2016 

ITHURBIDE Philippe , Senior Economic Advisor

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Negative rates: a potentially counter –productive and stress inducing measure
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