18 December 2020

What would negative interest rates mean for savers?

With yesterday’s news that interest rates will hold at a record low 0.1%, we’ve asked our investment experts, Asset Intelligence, to share their thoughts on negative interest rates and what they might mean for investors.

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Not so long ago, a few years back in what we might reasonably refer to as the ‘old normal’, everyone was familiar with one of the key foundation stones of finance.

In return for taking the risk of lending your money to a debtor or depositing your capital in a bank, you received a just reward: interest.

Positive interest.

Nowadays of course, in the ‘through the looking glass’ financial markets with which we have lived ever since the financial crisis, things are not always so simple.

Many nations already have negative interest rates in place and there is speculation that the UK might well follow along soon.

What has the Bank of England said about negative rates?

In more than three centuries of history, the Bank of England (BoE) has never imposed negative interest rates on depositors. Indeed, at the latest meeting of the Monetary Policy Committee on 17 December, the Bank held its benchmark rate at the record-low rate of 0.1% rather than lower it into negative territory.

But with the BoE’s own forecasts suggesting the UK could face its worst recession in 300 years1 thanks to the pandemic, policymakers have admitted that this once unthinkable option is now under review. 

In May, BoE Governor Andrew Bailey told the Treasury Committee that the Monetary Policy Committee (MPC) was “looking very carefully2 at the impact of negative interest rates in other parts of the world, adding that it would be “foolish3 to rule them out as a potential policy tool.

The soft pivot in tone – Governor Bailey had previously said that negative rates were not being contemplated – has raised interest in the potential impact this move could have for investors. Even though the Bank may have held off from pulling the trigger in December, the possibility remains very much live as we head into 2021.

Why would a central bank impose negative rates?

A negative interest rate policy (NIRP) effectively charges commercial banks to deposit their reserves at the central bank.

The aim of levying this penalty is to encourage banks to use their funds to lend to households and businesses instead, thus stimulating the economy. Negative rates on cash, which are likely to feed through into government bond yields, also encourage savers to invest in riskier assets, thus providing additional capital to companies. Another objective may be to put downward pressure on the currency to boost exports, though few central banks would explicitly admit this.

Though traditionally considered a last resort, both the European Central Bank and the Bank of Japan have adopted NIRPs in the last few years in order to support their challenged economies. Central banks in Switzerland, Denmark and Sweden have also held borrowing costs below zero over the last five years, though Sweden’s Riksbank brought its main repo rate back to zero at the end of 2019.4

The BoE is now reviewing the experience of negative rates in these countries, with Bailey noting that there have been “mixed reviews” over their effectiveness to date. In particular, some critics complain that negative interest rates reduce banks’ profitability, which may reduce their willingness to extend credit to some borrowers – thus having the opposite effect of that intended.

How do negative rates affect investors?

The prospect of very low or negative interest rates is likely to act as a key driver for the local bond market. When rates are expected to fall, bond prices tend to rise (and thus their yields fall) due to the fixed nature of the income streams that bonds provide. According to Tradeweb data, the value of UK gilts with negative yields at the end of July reached over £1.3 trillion, or over half of the total market6.

Negative yields primarily affect fixed income investors, who find themselves effectively paying to lend to borrowers if they hold bonds to maturity. Indeed, historically low bond yields are one reason why income portfolios have tilted towards dividend-paying equities in recent years.

However, even negative yields don’t necessarily imply losses for a bond investor – 10-year German bunds returned nearly 6% in 20197 despite carrying a negative yield for most of the year. This is because their capital values continued to rise. Demand remained high due to general risk-off sentiment among some investors, as well as the belief that rates and yields could yet fall even further into negative territory.

Diversifying across the global market is one way of protecting against negative rates in the UK and other developed nations. However, investors should remember that any search for higher returns away from high-quality sovereign bonds likely means accepting more risk in portfolios.

The outlook for the economic recovery and monetary policy remains highly uncertain. However, it is a good time for UK investors to gain a better understanding of how negative interest rates might affect their savings in case the Bank of England does indeed choose to pursue this path next year.

Even in a negative-rate environment, maintaining a balanced and diversified portfolio will remain the best way to achieve investment goals. 

If you would like to discuss your financial situation, please get in touch.

Past performance is not indicative of future results.

Sources

1. https://www.reuters.com/article/us-health-coronavirus-britain-boe/bank-of-england-sees-worst-slump-in-300-years-as-coronavirus-bites-idUSKBN22I3BV

2. https://uk.reuters.com/article/uk-health-coronavirus-britain-boe/boes-bailey-re-thinking-sub-zero-rates-but-says-reviews-are-mixed-idUKKBN22W23M

3. https://www.cityam.com/boes-andrew-bailey-it-would-be-foolish-to-rule-out-negative-interest-rates/

4. https://www.riksbank.se/en-gb/press-and-published/notices-and-press-releases/press-releases/2019/repo-rate-raised-to-zero-per-cent/

5. https://www.reuters.com/article/britain-bonds/uk-sells-first-government-bond-with-a-negative-yield-idUSS8N2CU0EP#:~:text=LONDON%2C%20May%2020%20(Reuters),slightly%20less%20than%20they%20lent.

6. https://jp.reuters.com/article/instant-article/idUKKCN24Z2BK

7. https://www.reuters.com/article/us-eurozone-bonds-returns-graphic/wunderbar-investors-set-for-best-german-bond-returns-in-five-years-idUSKBN1YL2AO