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If you’ve never heard of negative interest rates before, you’re not alone. For many years, such an idea has remained exactly that amongst economists – an idea which could work in theory, but perhaps not in practice (similar to how scientists typically regard faster-than-light travel).
Yet the idea of negative interest rates has recently been tried by economies such as Sweden, Japan and even the European Central Bank (ECB) in recent years. At the time of writing in autumn 2020, there is now even talk that the Bank of England (BoE) might introduce such rates to the UK in an attempt to stabilise the economy in the wake of coronavirus. What effect would this have on households, savers and investors? What exactly does this mean, and how likely is it to be introduced in the coming months?
Here at Elmfield Financial Planning in Padiham, Burnley, Lancashire, our financial planners offer some answers to some of these important questions. We hope you find this content useful. If you’d like to speak to an independent financial adviser then you can reach us via:
T: 01282 772938
What are negative interest rates?
The BoE’s base rate currently sits at an historic low of 0.10%. The base rate has a huge impact on the economy, since it is used by banks and building societies to set their own interest rates. For instance, if the BoE raises its base rate – say, to 0.25% – then commercial lenders are likely to increase interest rates on their variable rate mortgage products. In similar fashion, should the base rate be lowered (as it was earlier in 2020), then banks usually also lower the interest rates offered to customers on their savings accounts.
This is fairly straightforward, but things get confusing when interest rates enter negative territory. Can you imagine your bank account paying a -1% interest rate on your savings, for instance? In theory, this is what negative interest rates could imply – although most banks would likely dress this up in a different way (e.g. offering a 0.50% interest rate but requiring that you pay a regular charge for the privilege of having the account). Or, could you conceive of a scenario where you eventually pay back less than you borrowed when taking out a mortgage? This might sound bizarre, but it’s what’s currently happening in some European countries.
How might negative rates impact investors?
Negative interest rates would clearly impact upon savers and borrowers. The former would be driven to spend money (since they lose out by holding it in the bank), whilst the latter would be encouraged to buy property by taking out a mortgage. This is, in fact, an important reason why the BoE is considering the introduction of negative rates – it could help to encourage consumer spending as the UK economy struggles to move out of COVID-induced stagnation. Yet what might be the implications for investors?
Here, the effects of negative interest rates can be less clear – but certainly no less important. First of all, this could be good news for equity investors. Lower interest rates can increase the value of future earnings made by companies. These earnings are then eventually paid out to company investors, which encourages the appreciation of share value. For those investors who are still nursing their wounds from the stock market plunge earlier in 2020, this could be a very welcome development to help their portfolio’s recovery.
For bond markets, however, negative interest rates would likely have a very different impact. On the one hand, this could boost UK bond markets – since bond prices increase when yields go down. Yet on the other hand, these lower yields would lower the income that bond investors would be able to generate in the future. This is because bonds are a bit like “IOUs” – i.e. you (the investor) lend money to a government or company when buying a bond, on the promise that this will be repaid to you over time with interest. In a low-interest rate environment, bonds will offer lower yields because the interest rate on offer will be lower.
Within a negative interest rate environment, however, investors could end up paying borrowers (e.g. the UK government) when lending money to them through the form of a bond. This might sound like an irrational thing for an investor to do, but there can be instances where it can make sense. First of all, there can still be a portfolio diversification benefit – allowing you to reduce risk exposure during times of economic difficulty/downturn. Secondly, they can act as an important hedge. Remember, for global fixed income investors, foreign currency securities are hedged to address fluctuations in the value of different currencies. This can make negative-yield bonds attractive, depending on the situation. In 2019, for instance, the yield of the 10-year German Bund stood at -0.6%. For someone investing in US dollars this might seem unappealing, but it’s important to remember that currency hedging rates are based on the difference in short term interest rates between Germany and the US. At the time, those of the latter were higher than Germany’s – meaning that US investors gained by hedging euro exposure.
If you are interested in starting a conversation about your own financial plan or investments then we’d love to hear from you. Get in touch to arrange a free, no-commitment consultation with a member of our team here at Elmfield Financial Planning in Padiham, Burnley, Lancashire.
Reach us via:
T: 01282 772938