What Negative Interest Rates Mean For Your Portfolio

What Negative Interest Rates Mean For Your Portfolio

September 2016

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Japan’s use of negative interest rates has given investors a new worry. When the Bank of Japan lowered rates from 0% to -0.1%, the yen was expected to fall in value. Instead it rose, which raised fears that the world’s monetary authorities are running out of tools to fight sluggish economic growth. If monetary policy becomes ineffective, what will happen to your investment portfolio?

Over the last few years, investors have demonstrated strong faith in the ability of monetary stimulus to drive equity prices higher. Markets around the world have, therefore, greeted a vast array of monetary programs with the thunderous applause of rising prices.

Monetary stimulus lowers the cost of borrowing, which encourages consumers and businesses to spend more. As the increased spending fans out through the economy, the resulting rise in corporate earnings helps drive equity prices higher.

Yet, that does not always work. If consumers and businesses are not willing to spend more, lowering rates to generate faster growth is about as effective as pushing on a string. The fact that monetary authorities have been forced to implement repeated rounds of easing tells us that low rates have probably not added much to spending.

Still, increased lending is not the only way that money flows stimulate an economy. When growth is slow and interest rates fall, the country’s currency value also tends to decline. A cheaper currency makes exported goods less expensive in overseas markets, generating faster growth through rising export sales. It can be argued that policy moves in Japan, Europe and other export-oriented economies are aimed more at manipulating currencies than at stimulating additional borrowing.

When rates drop below 0%, however, the economic dynamics change significantly. While a fee on deposited money provides increased incentive to lend, people can also find other ways to avoid being charged a fee. Bank depositors, for example, could simply buy a secure home safe. And if banks cannot collect added fees from depositors, they may charge borrowers higher rates or scale back their business to concentrate solely on highly profitable loans.

The widespread trend toward extremely low interest rates also tends to discourage money flows that help lower currency values. Over the last few years, investors sourced money in countries with low rates to invest in countries that offered markedly higher rates, creating a money flow that both caused and benefitted from falling currency values. But when the difference in rates around the world narrows, the flows that moved currency values also decline.

Investors do not need strong economic growth, however, to benefit from monetary easing. Monetary injections tend to flow directly into investments when there is tepid economic response. That gives investors two ways to win. If stimulus increases economic growth, rising earnings ultimately push equity prices higher. When the stimulus does not generate faster growth, assets tend to soak up injected money and investment prices still rise.

When monetary easing directly drives investment prices up, the associated rise in investor optimism normally adds more fuel to the rally. Time and again over the last several years, the sheer belief in the power of monetary stimulus unleashed a torrent of investor money that magnified the effect of the original injection.

That implies, however, that a loss of faith in monetary policy could have profound implications. The emerging questions about the effectiveness of monetary measures suggest investor faith is wavering. At some point, as in the tale of the emperor’s clothes, investor faith in monetary easing could simply dissolve.

As with the economic impact of easing, the direct monetary effect on asset values also has an objective limit. Without earnings growth or other fundamental gains, asset valuations rise along with prices. In the early stages of rallies, that helps assets recover from unreasonably low valuations. Eventually, though, valuations rise to the point that investors balk at paying higher prices.

Since the end of the last recession in 2009, monetary stimulus has turbocharged the rise of equities and other assets. Arguably, asset prices have benefitted immensely over that time. But that could not go on forever. Japan may be only the first country to bump up against the limits of monetary easing. And even in countries that still have room to ease, the loss of investor faith in monetary policy may weaken the impact stimulus will have on investments.

Still, we need to realize that the loss of monetary effectiveness will not end equity rallies around the world. As long as economies and corporate earnings continue to grow, equity prices can still rise. Market gains may not come as quickly as they did during the heady days of monetary easing, but the loss of effective stimulus programs should not block the bull market from trudging higher, even if the pace slows.

This material is presented for informational purposes only and should not be construed as individual tax or financial advice. KeyBank does not provide legal advice. KeyBank is Member FDIC. Key Corp. © 2016. CFM 20160520-85651

 

This article was written by Bruce McCain from Forbes and was legally licensed through the NewsCred publisher network.

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