The solution may be the problem.
That’s Wall Street’s emerging consensus on negative interest rates, which have been implemented around the world in a bid to catalyze economic growth.
489 million people are currently living in countries with official negative interest rate policies, according to Bank of America Merrill Lynch strategist Michael Hartnett.
A big concern is that this negative-rate experiment will achieve nothing more than currency devaluation, without triggering any growth. Deutsche Bank strategists led by David Bianco said in a note Sunday (emphasis ours):
Escalating the currency war will bring mutually assured destruction, in our opinion. The WMD are negative interest rates. Central banks must stop the proliferation now. Negative rates don’t stimulate beyond currency devaluation.
There are two key aspects to the fears over negative interest rates.
Fear No. 1
First, negative interest rates will hurt banks. They will erode a key measure of bank earnings called net interest margin, which is the difference between what banks get paid by borrowers and what they pay for deposits.
Negative rates are a “dangerous experiment” for banks, Morgan Stanley analysts led by Huw van Steenis wrote on Wednesday.
They incentivise banks to shrink, erode profits, and discourage cross-border lending. Negative rates are likely to erode bank profits by 5% to 10%, according to Morgan Stanley’s research.
And that has knock on effects for lending, which can hit the economy that central bankers are trying to stimulate.
Michala Marcussen, global head of economics at Societe Generale, explains that the key difference between a crisis that turns systemic, and one that passes causing less damage, is what happens to bank balance sheets.
She said in a recent note:
The fear today is that business models are under stress from a durably low interest rate environment. Something central banks may want to consider carefully.
Fear No. 2
That brings us to the second problem. There is a view that the decision to go negative is a sign that central bank policy isn’t working. Here is Marcussen again:
This leads us to an important point with respect to monetary policy, namely the confidence that unorthodox monetary policies still work. We have long held the concern that unorthodox monetary policies come with diminishing marginal returns.
Of course, Marcussen isn’t the first person to say that unorthodox central bank policy isn’t working. It does seem however that the negative interest policy experiment in particular has added fuel to the fire. Hartnett at Bank of America is now writing about “quantitative failure,” for example.
Investors may already be signalling their doubts about the policies.
Credit Suisse rates strategists led by Helen Haworth on Friday noted the markets’ reaction to the Bank of Japan decision to go negative.
The yen strengthened and the Nikkei stock index weakened, which is pretty much the opposite of what should happen when a central bank eases.
That underscores “markets’ lack of conviction in central banks’ ability to reflate,” according to Haworth.
That, in turn, is creating selling pressure, according to Haworth’s Credit Suisse colleague Sean Shepley. Shepley, who is a macro trading strategist, said in a note over the weekend:
Part of the pressure for de-positioning comes from a loss of confidence in policymakers’ ability to boost growth. We believe that a change of course is required, ideally towards greater use of fiscal policy and reduced reliance on negative interest rates.
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