IN the past 18 months, the European Central Bank (ECB) as well as the central banks of Japan, Denmark, Sweden and Switzerland have cut key interest rates to below zero to spur growth. This unprecedented use of the negative interest rate policy and its growing prevalence are a causing a rethink in investment and retirement strategies across the globe.
The key objective of this policy is to boost growth, but it does not seem to be working. In Japan, the loan growth of banks was at its slowest in the last three years in March. Deposits, however, increased 3% during the month, slightly lower from 3.1% in February.
The most obvious anomaly is how the yen responded to the Bank of Japan’s (BoJ) January announcement that it would cut interest rates to negative. Instead of weakening, which would spur growth, the currency strengthened.
Vasu Menon, vice-president and senior investment strategist at OCBC Singapore, says this phenomenon occurred because many considered the yen a safe haven amid the uncertainties in China. “Instead of weakening, the yen shot up because the move was smack in the middle of the crisis in China and the renminbi was weakening. If you have uncertainties around the world, people just gravitate towards the yen as a safe haven.
“Sometimes people regard it as being even safer than the US dollar. In fact, the yen is one of the best performing currencies in the world. This makes it difficult for Japan to really make the negative interest rate policy effective.”
Impact of negative bond yields
Negative rates have also had a bearing on bond yields globally. According to Bank of America Merrill Lynch, the amount of negative-yielding debt rose to a record US$13 trillion after the Brexit referendum on June 23, from US$11 trillion before the vote and almost zero in 2014.
Kristina Fong, economist and head of research at RAM Rating Services Bhd, says the pronounced downward pressure on global bond yields has been largely motivated by the expectation that Brexit would exacerbate the already-low interest rates in developed markets.
“In particular, investors are seen to be pricing in a further delay in the Federal Reserve’s raising of US interest rates and additional monetary stimulus by the Bank of England and the ECB, to support economic growth on account of Brexit. Nevertheless, Malaysian bonds were a beneficiary of the event,” says Fong.
“The days following the vote were characterised by aggressive yield hunting on the part of global investors, which saw a significant net inflow of foreign investor funds into the Malaysian bond market to the tune of RM5.7 billion in June, bringing foreign investor bond holdings to a 19-month high of RM235.2 billion.”
She says this was unlike the trend observed in other episodes of global volatility and uncertainties in the past. What makes this episode distinct from previous ones is the largely prevalent negative or zero interest rates and negative bond yields, which were absent before.
“The taper tantrum in 2013 and China’s sudden currency devaluation and stock market ‘flash crash’ of 2015 elevated Malaysia Government Securities (MGS) yields and saw a decline in the foreign holdings of domestic debt securities,” says Fong, adding that global volatility will continue in the second half of the year.
Negative yields will create a volatile bond market, as investors will not be motivated to hold on to the securities until maturity. As a consequence, Dr Yeah Kim Leng, professor of economics at Sunway University Business School, says the bond market will be subject to higher risk. “At the same time, people are looking at higher-yielding bonds, which carry higher risk. That is something unprecedented in the bond market. If inflation continues to be low, then the risk of investing in bonds will be lower.”
Teh Chi-cheun, CEO and executive director of Pacific Mutual Fund Bhd, believes governments will continue to utilise this tool — at least for the next few years. “We have only seen negative interest rates since the global financial crisis, and that is not even a decade old. Japan just introduced negative interest rates this year while the ECB went deeper into negative territory.
“Hence, for the impact to be effective, negative rates will have to remain for the next two to three years, easily. For Japan, as it only introduced negative interest rates this year, it will likely continue for a longer period compared with the ECB.”
This environment raises concerns about the future of the already fragile global economy. It will also incite investors to take on additional risk to compensate for the lower rate of returns from assets as the traditional risk-return trade-off is no longer applicable. This poses a dilemma for pension funds and insurance companies whose mandate is to invest in lower-risk assets, says Menon.
“Pension funds and even insurance companies that need to put their money to work can’t because typically some of them have to buy bonds. Many bonds that they buy are the safer ones [which today are] yielding negative interest rates.
“So, pension funds are scratching their heads wondering how they are going to put their money to work. If rates are -0.1% to -0.2% and they can’t go into risky assets, they may have no choice but to move up the risk ladder so they can get better returns.
“This may not be a good thing because they may be taking undue risk. So, they go into private equity, into high-yield bonds, which may be good and bad, because they were not designed to do these sort of things.”
It may not be positive for growth. Menon says when consumers know that their money is not going to grow very much for the next few years, the only way for them to grow it is to save even more than before.
“This applies especially for those building their nest egg for retirement. If interest rates were higher, it would help them grow their money. So, instead of using this policy to boost spending, it may prevent people from spending and even encourage them to save more,” he points out.
If this is prolonged, Teh says it can result in high risk for the entire financial system without adequate compensation of returns. “These negative interest rates can push investors to take on additional risk due to the lack of yield. At some point, these policies will lose their efficacy and the confidence of investors.”
There is evidence that this already happening. Danny Chang, head of managed investments and product management at Standard Chartered Bank (M) Bhd, says the lower interest rates are fuelling carry trade (borrowing at lower interest rates to invest in higher-yielding assets), which leads to further yield compression.
“With US dollar borrowing rates below 1.75% per annum, investors are borrowing in the US dollar and investing in yielding assets that pay income above this level, such as high-yield and emerging market bonds.”
Yeah paints a starkly darker picture, saying it can result in excessive fear of a market collapse. “There is a certain point in time when the effects kick in, which can result in an excessive fear of market collapse or worse still, a surge in demand when people suddenly realise that the money is becoming worthless and start chasing yields as a hedge against inflation.
“The potential for asset bubbles becomes very likely. So, the risk is always there for market disruption, especially when there is so much liquidity in the financial system.”
Negative interest rates are not the only issue. Many central banks have reduced their key interest rates, including Bank Negara Malaysia, which lowered its overnight policy rate (OPR) by 25 basis points to 3% in mid-July, citing concerns about the Brexit fallout. The move surprised many economists and industry observers.
Investors will have to brace themselves for such market events, says Yeah. “[Negative and] low interest rate policies are going to create a lot of market swings, so investors will have to brace themselves for them, whether in bonds or equities. If there is a further cut in interest rates and quantitative easing, it can build up to a situation that creates an overreaction. Markets tend to have tipping points, which are really unknown at the moment.”
Others do not think a financial crisis will be triggered by negative interest rates alone. While not discounting the possibility, Affin Hwang Asset Management Bhd chief investment officer David Ng believes a crisis could be triggered by a convergence of events, such as a surge in inflation.
“On the fixed income side, there could be a significant pullback if there is a growth scare. At this juncture, it looks unlikely. But if for some reason, growth starts to pick up fast, inflationary expectations start to turn around globally, then you will see yields reverse,” he says.
“If there is a very certain acceleration in expectations, the equity market in emerging markets could see a pullback because of a stronger US dollar immediately. But if growth continues, then it should favour equities and growth assets.”
But with so much money ploughing into fewer assets that can deliver satisfactory returns, prices of assets will continue to inflate, creating the risk of unsustainable bubbles that are set to burst with serious repercussions. Is there a real risk of this happening?
Menon does not think so. “You do have money flowing in the higher yield segment of the bond markets, but I don’t see money rushing in senselessly in a widespread manner.
“There has got to be irrational exuberance [before a bubble is created]. We do not have that right now. In fact, you have a lot of scepticism. If you look at many parts of the world, fund managers are cashed up and individuals are sitting on a lot of cash and waiting for tactical opportunities before going in to buy, and then cash out [later].
“While you cannot discount the probability of a 10% to 15% pullback, I do not see markets crashing because there is so much money on the sidelines — money goes in when you see pullbacks, which then help markets rebound. That explains why you see so much volatility.”