Interest rates feel the big chill

Things are getting decidedly chilly in the world of global finance. First it was low interest rates and zero interest rates. Now it’s sub-zero, or negative interest rates. What on earth is going on?

Negative interest rates are a new phenomenon introduced by central banks in major economies across Europe and in Japan to stimulate growth. Or so the theory goes. Never before have rates moved into negative territory so the effects are not fully known.

So what are negative interest rates and what do they mean, if anything, for Australia?

What is a negative rate?

Negative interest rates are where you in effect pay for somebody else to hold your money. Rather than earn interest on your money, you are paying interest.

In reality, individuals taking out term deposits or holding money at the bank are not paying for the privilege, although it does mean that rates are very low. So far at least, negative interest rates only apply to large companies in Europe and Japan who are paying to park their cash.

This is how it works. Central banks charge private and commercial banks interest to hold their cash overnight. The intention is to discourage banks from holding excess reserves and motivate the private sector to increase spending. For instance, as at April 2016 the European Central Bank was charging banks 0.4 per cent to hold their money overnight.

Positives and negatives

All this should encourage the private sector to spend. In theory it makes sense, but in practice there are fears that negative interest rates could also have some negative consequences.

Discouraging banks from holding on to money could lead to their having insufficient funds to lend to borrowers which would put a brake on economic activity.

In addition, if the banks do not pass on the cost of holding their funds with the central bank to their customers, this will put a squeeze on their profit margins which might also reduce their willingness to lend.

Corporations – and indeed private investors – could even decide that holding their money in the bank is not the best bet and so choose to withdraw cash from the banking system. Again this could stymie economic growth and distort financial markets.

Individual borrowers unaffected

Sadly, for personal borrowers negative interest rates are not coming to a bank near you any time soon.

For instance, in Australia the base rate is at an all-time low of 1.5 per cent but the average mortgage is closer to the 4.5 per cent mark. Similarly overseas, where negative rates exist, homebuyers pay interest on their loans.

In fact, Australia’s positive interest rates are having some negative consequence for the Aussie dollar as overseas investors look to our shores for better returns. While it looked at one point to be tumbling towards the US60c mark, it has since recovered to levels above US75c.

Implications for Australia

A stronger Aussie dollar is good news if you are travelling overseas, but it will also constrain the move to an economy no longer dependent on resources. The higher the dollar, the more expensive our exports and that makes it difficult to compete on the world market.

Low interest rates are not helping investors either. Term deposits attracting rates of around 2.4 per cent (i) will only just keep pace with inflation at the current rate of 1.3 per cent. (ii)

While holding your cash in the bank may seem increasingly less attractive, bonds may offer an alternative source of returns. With bonds, at least you stand the chance of the capital value of the bond increasing should interest rates fall further.

Despite the current downward pressure on local interest rates, it seems unlikely that we will move into negative territory. Even so, as investors we all benefit from understanding the ‘Big Chill’ in global interest rates and the flow-on effect to our economy.