20 August, 2020

Negative Interest Rates

  • To date the Reserve Bank of New Zealand (RBNZ) has relied on lowering the Official Cash Rate (OCR) to 0.25% and the Large Scale Asset Purchase programme to stimulate the economy. However, it has other tools including a negative OCR.
  • Expect the RBNZ to use multiple monetary policy tools.
  • A negative OCR is not a one-way bet. It is accompanied by numerous potentially negative side effects.
  • Even in countries where negative policy interest rates have been used bank term deposit interest rates have not fallen below zero.
  • Subject to how the economy evolves we expect a negative OCR, lower New Zealand Government Bond interest rates (particularly for terms to maturity out to five years) and materially lower bank term deposit interest rates.
Setting the Scene

The Reserve Bank of New Zealand (RBNZ) sets monetary policy with the aim of:

  1. Keeping annual inflation between 1% and 3% in the medium term, with a focus on keeping future inflation near 2%.
  2. Supporting maximum sustainable employment, while recognising that sustainable employment is largely driven by non-monetary factors.

In doing this it must have regard to the efficiency and soundness of New Zealand’s financial system, avoid unnecessary instability in New Zealand’s economy and financial markets, and ignore events which are likely to have a transitory inflationary impact.

With the Official Cash Rate (OCR) at 0.25% since March the RBNZ has been highlighting the “unconventional” monetary policy tools that it could potentially use to achieve its objectives. These policy tools include:

  1. Large scale asset purchase (LSAP) programme (also known as Quantitative Easing) – the purchase of Local Government Funding Agency bonds, New Zealand Government and Inflation-Indexed bonds.
  2. A term lending programme – the provision of low-cost, secured, long-term funding to banks.
  3. A negative OCR – setting the OCR at a level below 0%.
  4. Purchasing foreign assets – purchasing foreign government bonds.

To date the RBNZ has only used the LSAP programme. Most recently in its August Monetary Policy Statement, the RBNZ increased its LSAP from up to $60 billion, to up to $100 billion (to date the RBNZ has purchased $24 billion of bonds and is currently buying at the rate of just under $1 billion a week) and extended the term of the programme from May 2021 to June 2022. In agreement with the Minister of Finance the RBNZ has also raised the cap on the proportion of outstanding government bonds it can potentially purchase from 50% to 60%. This gives scope to further increase its LSAP programme in future.

Both the Government and RBNZ have introduced policies to cushion the adverse impact of COVID-19 on businesses and households. To date the RBNZ’s accommodative monetary policy has been successful in reducing interest rates (for example, mortgage interest rates are 0.75-1.10% lower than at the start of the year) which is reducing costs for households and businesses. In addition, exporters and importing businesses have benefited from the value of the New Zealand dollar being an estimated 4-10% lower (RBNZ estimate) than it would otherwise have been.

Where to Next?

With unemployment expected to increase to around 8%, inflation expectations falling well below 2% and significant ongoing uncertainty regarding the outlook for COVID-19 and its impact on the New Zealand economy the RBNZ concluded that there remains a downside risk to its baseline economic scenario. The Monetary Policy Committee indicated it will provide additional stimulus as necessary to meet its remit. This is a clear signal that unless there is a dramatic change in the outlook that further monetary policy stimulus is likely.

In the graph below the RBNZ has calculated an Unconstrained OCR which demonstrates the broad level of monetary policy stimulus from both the OCR and unconventional monetary policy tools. This suggests further stimulus may be necessary, given the reduction in the unconstrained OCR to date is below which has typically been required to rekindle economic growth after a recession. Although the reduction required will depend on numerous factors including the severity of the economic downturn, level of inflation and government stimulus.

Unconstrained OCR

Source: RBNZ

The LSAP programme has been successful in reducing New Zealand Government bond interest rates. As shown in the following graph New Zealand Government bond interest rates are much the same at around the OCR for all terms to maturity out to six years. Consequently, it will be harder for the LSAP programme to further reduce them without a reduction in the OCR and subsequent reduction in short term interest rates.

When the OCR was lowered to 0.25% the RBNZ said it would keep the OCR at 0.25% for at least a year – in other words until at least March 2021. Therefore, unless the RBNZ rescinds this undertaking due to a material change in the economic outlook, this suggests that government bond interest rates are likely to remain around current levels until after March 2021.

The RBNZ has indicated that in undertaking further stimulus it prefers not to overly rely on one monetary policy tool. Although the raising of the cap on outstanding bonds it can purchase allows it to further increase the size of its LSAP programme, perhaps to $120 billion, the move to a negative OCR or another unconventional tool gives it other arrows in its quiver to stimulate the economy.

New Zealand Government Bond Interest Rates

Source: Reuters Eikon, Jarden

Back in April 2020 we assessed the likelihood of negative interest rates in New Zealand as low. However, following last week’s Monetary Policy Statement we view the likelihood of negative interest rates being implemented in 2021 as much higher, despite the controversial nature of negative interest rates. Unsurprisingly, many others have come to the same conclusion with current market pricing suggesting a 0.37% fall in short term interest rates to -0.12% by August 2021.

The RBNZ expects that a negative OCR would have a positive impact on the economy, through the lower cost of bank funding being passed through into lower interest rates being charged to borrowers, until such time as term deposit interest rates were close to zero (term deposit interest rates are currently around 1.5%pa). At that time, any further reduction in the OCR would no longer reduce bank funding costs and therefore there would be no further scope for interest rates charged to bank borrowers to decline.

Consequently, the RBNZ would also consider a term lending programme. By providing low cost funding to banks the banks would be able to provide cheaper loans to households and businesses, while maintaining profitability. The RBNZ notes that term lending programmes in other countries have sought to directly encourage the supply of credit via including incentives for banks using the programme to expand their lending.

The final policy tool discussed by the RBNZ is the purchase of foreign assets. This tool has a dual purpose of putting downward pressure on the New Zealand dollar’s value and with more New Zealand dollars in circulation it would put additional downward pressure on New Zealand interest rates.

When considering the implementation of these policy tools the RBNZ outlines five principles which it considers when assessing the appropriateness of each policy tool and the appropriate size of the response. The principles are – effectiveness, efficiency, financial system soundness, public balance sheet risk and operational readiness (in the case of negative interest rates this includes the ability for banks systems and loan documentation to cope with negative interest rates. Currently banks are upgrading systems, a task which we expect to be completed by year end). Given the varying degrees of benefits and adverse effects of each of the policy tools we expect a mix of policy tools to be used.

Negative Interest Rate Assessment

Views on the value of negative interest rates are mixed. To date both the Reserve Bank of Australia and US Federal Reserve have ruled out using negative interest rates. However, the Bank of England is actively considering their use. Furthermore, the Bank of Japan, European Central Bank and others continue to have negative interest rates. However, the Swedish Riksbank, the world’s oldest central bank and first central bank to implement negative interest rates back in 2015, has recently abandoned them viewing the adverse side effects outweigh the positives of their long-term use. The Riksbank Governor, Stefan Ingyes, argues negative interest rates were a success, but accepts that if they continued indefinitely the adverse side effects would outweigh the positive impact.

The negative impacts of extremely low and negative interest rates include:

  1. Pension funds struggling to meet their In other words, struggling to pay the promised pensions to their beneficiaries without taking undue risk.
  2. Banks, insurance companies and other investors taking excessive risk to obtain adequate Those that do not take greater risk struggle with insufficient investment returns. Effectively a lose-lose scenario. Furthermore, if banks cannot lend profitably, they have little incentive to lend. Finally, adequate bank profitability is needed to ensure banks remain appropriately capitalised and can continue to lend.
  3. Subsidising “zombie” companies (companies that can just cover running and interest costs, but no ability to repay) thus slowly eroding economic growth and Any increase in interest rates would tend to tip a zombie company over the edge, resulting in it going out of business or being materially restructured.
  4. Encouraging economy wide misallocation of resources.
  5. Savers are unfairly punished at the expense of While borrowers have more to spend because of low interest costs, savers have less interest income and thus less to spend.
  6. People and companies are encouraged to hoard cash. Germany’s largest safe maker, Burg-Wächter, experienced a 33% increase in sales after the European Central Bank reduced its deposit rate below zero.
  7. Inflated asset prices potentially creating an asset bubble (a rapid rise in the price of an asset without fundamental support). At the very least inflated asset prices result in lower future returns (we recently reduced our long-term return assumptions across all asset classes) or even losses should interest rates rise. On the positive side we expect interest rates to remain low for an extended period.
  8. Rather than encouraging spending the prospect of low returns often encourages people to save more aggressively or spend less to eke out savings.
Very Low Interest Rates Encourages Savings

Source: Bloomberg

Near zero or negative interest rates provide a morale hazard for governments to potentially act irresponsibly by continually borrowing to fund poor quality spending which might not occur if there was a cost to the debt. For example, Japanese Government debt to gross domestic product (GDP) has risen from around 70% GDP in the early 1990’s to around 240% With 0% interest rates funding this debt mountain is not a problem. However, at an interest rate of just 1% it equates to 2.4% GDP annually.

Impact on Investors Observed Overseas

Typically, when negative interest rates have been used by central banks, bank deposit interest rates have almost always fallen to just above zero (although we observe very brief periods in Denmark when bank deposit interest rates were negative). However, while term deposit interest rates may hit a 0% floor some banks in countries which have negative interest rates charge wealthy clients a fee for large deposits. For example, last year UBS introduced a 0.6% per annum charge to customers that deposited more than €500,000 to pass on the cost of negative interest rates.

On the other side of the coin mortgage interest rates have typically fallen to anywhere between 1.25% and 3.0% (clearly the use of other policy tools such as term lending programmes are having an impact in countries where mortgage interest rates have fallen more). However, there are also cases of negative mortgage interest rates. Last year Denmark’s third largest bank, Jyske Bank, offered borrowers a 10-year loan at -0.5%. In this case at each monthly repayment the borrower paid nothing, and the bank reduced the principal outstanding by an amount equivalent to the interest due to be paid by the bank. It should be noted that borrowers are still required to pay fees and charges to compensate for the costs of arranging the loan.

Outlook for New Zealand Interest Rates

It goes without saying that the level of New Zealand interest rates in the future will depend on how the economic outlook evolves. However, given the slack in the economy that has developed due to COVID-19 and the limited success with achieving the inflation goal over the past decade we would not be surprised to see further monetary policy stimulus on a regular basis. We note that the RBNZ sees potential downside to its current outlook and is ready to provide additional stimulus as necessary to achieve its employment and inflation objectives. We expect that the RBNZ will stick to its undertaking to keep the OCR at 0.25% until March 2021, using other policy tools in the interim. However, post March 2021 we expect the OCR to be dropped into negative territory. Consequently, Government bond interest rates for terms to maturity out to five years will likely head towards zero or below, and bank term deposit interest rates are expected to fall below 1%. In fact, with the banks funding gap between household borrowing and deposits expected to disappear and probable provision of a term funding program by the RBNZ a gradual decline in term deposit interest rates to under 0.5%pa has to be a real possibility.

This advice is general or “class” in nature, not specific or personalised to you. It does not take into account your financial situation or goals and, accordingly, does not constitute personalised financial advice under the Financial Advisers Act 2008. If you require personalised financial advice, there is a process to go through before that can be provided to you.

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