Most economists are tempted to rely on incremental analysis to
explain the spread of negative interest rates and their implications
for the global economy and markets. This is understandable, yet the
inclination to focus primarily on marginal changes could be overly
partial and even misleading — especially for market participants who
must navigate the unintended consequences of sub-zero yields,
including the possibility of “tipping” events.
The conventional argument of economists goes something like this:
The actions of central banks and the market pricing of government
bond yields have proved that zero no longer constitutes a lower
nominal bound for interest rates. As a result, the effects of
negative rates are best analyzed in terms of deltas — that is to
say, by extrapolating the marginal impact of a change in rates (say
from minus 0.2 percent to minus 0.3 percent), as opposed to
assessing levels as a whole (how negative and for how long). Despite
the historical anomaly of negative nominal rates, most economists
are inclined to apply the traditional analysis of a continuum of
pricing, behaviors and economic effects.
I am not so sure that this necessarily is the right approach.
Three developments on the ground support this skepticism and suggest
the need for more open thinking and analysis:
First, much of the institutional setup for providing financial
services to millions in systemically important advanced economies
was not designed to operate for long with negative nominal interest
rates, and with the associated flattening of the yield curve. For
example, with pressures on net interest margins, banks face greater
challenges in intermediating funds and are increasingly inclined to
turn away deposits. Moreover, providers of long-term financial
savings, protection and assurances — from pension funds to insurance
companies — find it harder to meet client expectations of meaningful
safe returns many years in the future. There are no meaningful
substitutes available in the short-term.
Second, persistent negative interest rates may compel a growing
number of individuals to disengage from a financial system that now
taxes them for placing deposits and savings. No wonder the sales of
home safes soared in Japan after the Bank of Japan unexpectedly
decided to follow the European Central Bank into negative policy
rate terrain.
The longer these two sets of circumstances prevail, the greater
the pressure on individuals and companies to self-insure rather than
rely on the system’s collective insurance facilities. In turn, that
risks translating into slower economic activity, as well as more
fragmented financial markets that are harder to monitor, influence
and regulate.
Third, if negative interest rates go beyond perceived
thresholds of reasonableness and sustainability, the operating
modalities of certain markets could change. This dynamic may be
playing out in the recent puzzling behavior of foreign-exchange
markets after both the Bank of Japan and the ECB adopted and
reinforced their negative rates policy.
Rather than depreciate, both the yen and the euro have
appreciated. Although some of these counterintuitive moves
reflect a somewhat more dovish Federal Reserve, which has
mitigated expectations of highly divergent interest rates among
the world's central banks, there could well be something bigger
in play: Specifically, the dilution of interest-rate
differentials as the main driver of currency values,
particularly as greater attention is paid to stock effects,
including the ability of citizens to repatriate capital from
abroad. This is an especial concern for Japan.
All this calls for further analysis and more open- mindedness
from economists when assessing how the global economic and
financial system is likely to operate now that about one-third
of global government debt is trading at negative nominal yields.
Specifically, stock effects and behavioral influences could
alter the conclusions that are derived from an analysis based
primarily on interest-rate differentials and other relative
pricing considerations.
Should this prove to be the case, and I suspect it will, the
implications for investors and traders would go well beyond the
potential of a new set of unintended and unusual potential
headwinds to economic growth and corporate earnings. The new
understanding would require altering pricing models for foreign-
exchange markets, recasting assumptions about correlations among
different asset classes, being more open to the possibility of
sudden market jumps and air pockets, and factoring in a larger
liquidity risk premium.
Mohamed El-Erian is the chief economic adviser at
Allianz SE. To read more of his blogs,
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