What are negative interest rates and what do they mean?

What are negative interest rates?

Negative interest rates are an unorthodox monetary policy used by central banks to combat persistently difficult economic conditions. When central banks set negative interest rates, depositors – often commercial or regional banks – must pay the central banks interest to store their money with them. This encourages would-be depositors to invest, rather than save, and therefore stimulates economic growth.

Conventional interest rates, on the other hand, are positive and denote that a depositor will receive interest on any deposits they hold with central banks or other financial institutions.

Negative interest rates are often only applied to deposits or reserves over a specific amount, although banks in countries such as Denmark have also applied negative interest rates to mortgages and certain other loans to consumers.

How does a negative interest rate work?

Negative interest rates are designed to discourage commercial and regional banks from depositing money with central banks, while making it more attractive to give out loans. Central banks achieve this by setting negative rates, which mean that regional banks will often lower the interest rates on the loans they give out in order to have somewhere else to store their money.

For example, if the central bank deposit rate is -1%, commercial and regional banks might lower their rate on loans to 0% or 0.5% in order to make taking out a loan more attractive to businesses and individuals.

As a result, the banks can ‘store’ their money with these individuals and businesses without having to pay the central bank deposit rate. While they might not receive much or any interest on these loans, they won’t be losing money outright by storing any excess reserves with the central bank.

In doing so, there will be more money in the economy through increased borrowing, which will hopefully lead to greater spending and economic expansion.

Negative interest rates on mortgages and other loans work by requiring the borrower to repay less money than they initially took out. For example, if a consumer took out a loan to the value of £1000, and the rate of interest was -0.50%, the consumer would only have to repay £995. If the rate of interest was instead a more conventional 0.50%, then they would have to repay £1005.

To explain how negative rates achieve greater spending and borrowing, we should look at two types of monetary policy: tight and loose.

Tight vs loose monetary policy and negative interest rates

Tight monetary policy involves a central bank increasing interest rates because consumers are saving too little and spending too much. The increased rates should mean that people are more incentivised to save money because, with higher interest rates, they can expect a greater return on their deposits. Tight monetary policy is implemented by central banks to prevent an economy from ‘overheating’ by reducing inflation levels through managing productivity and spending. When this happens, less demand is placed on goods and services, which can reduce the rate at which inflation rises.

On the other hand, loose monetary policy is implemented when people are saving too much and spending too little - negative interest rates are a tool of loose monetary policy. Loose monetary policy means that central banks will cut their interest rates in order to encourage spending because people will not expect better returns on their savings if they hold onto their money for longer.

In turn, this will help to boost demand for goods and services in an economy, which should facilitate increased supply. Hopefully employment will also rise, or at the very least, unemployment will be brought under control.

What do negative interest rates mean for a country’s economy?

Negative interest rates can mean that there is an underlying problem in a country’s economy. This is because the central bank will impose negative interest rates in times of weak economic growth or if the economy is suffering from deflation.

Deflation tends to deter investment because it signals a declining demand for products but a stagnant or increasing supply. This can be even worse if there is a deflationary spiral – an undesirable economic environment in which prices fall during an economic crisis in response to decreased aggregate demand, lower wages and restricted production. In turn, these factors lead back to even lower prices, even lower production and greater deflation.

Negative interest rates can also help to stimulate growth through increasing consumer demand for products once businesses and consumers have more capital to spend after taking out loans with attractive rates.

However, prolonged use of negative rates could mean that economies suffer. For example, negative rates can affect consumer and investor confidence because they can be a sign that an economy is slowing down, or that growth is restricted. In turn, this could mean that foreign direct investment in an economy decreases, and the boost to exports that a country was expecting never precipitates.

Overall, negative interest rates are widely classified as unsustainable and are usually only used as a last-ditch measure to prevent an economy from falling into a state of deflation.

What do negative interest rates mean for financial markets?

Negative interest rates have unique effects on different financial markets. To explain this more clearly, each section below is dedicated to the effects of negative interest rates on a specific market such as forex, shares and bonds.

Negative interest rates and forex

If a central bank sets a negative interest rate on deposits, it will often weaken the currency it issues compared to other currencies that it is paired with on the forex market.

This is because negative interest rates lower the returns investors will receive by buying and depositing a country’s currency, causing them to move their investment to a country where the interest rate paid on deposits is higher. This could actually cause a greater reduction in demand for a negative interest rate currency, which would further help to weaken its value on the forex market.

This can be good for traders who hold short positions in this currency on the forex market, but it can also mean that traders or investors who are long, or who have reserves of the currency in question, could stand to incur losses as it falls in value.

Negative interest rates and shares

Negative interest rates can mean that a country’s banks could experience reduced demand for their shares. This is because of the expected slowdown in the banking sector, which usually occurs because banks feel a strain on their margins as a result of lower interest rate revenues.

However, other industries in an economy, such as manufacturing, could receive a boost from investors as the increased money in an economy helps drive increased production. Market participants should carry out a fundamental analysis of a company before taking a position on their shares.

This is especially true in negative interest rate environments, because companies might just be capitalising on the lifeline thrown to them from cheaper loans, without making financially sound investments. These companies could still fail after the negative rates are reversed, because they will have large debts to repay – just at lower rates than usual.

Negative interest rates and bonds

In normal economic conditions, interest rates and bonds have an inverse relationship, meaning that an increase in interest rates will cause bond prices to fall. This is because, if interest rates rise, investors could receive more money by investing in these higher interest opportunities than in the now lower interest bonds.

In negative interest rate economies, bonds issued before the rates went negative are often sought after by investors as attractive ways to store their money. This means that the price of these previously-held bonds will increase, which can also be a good trading opportunity for speculators using CFDs and spread bets.

Learn more about the relationship between interest rates and bonds

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Examples of countries with negative interest rates

Since the practice of imposing negative interest rates is unconventional, countries with negative interest rates are exceptions to the norm. They have often set negative interest rates to counteract an underlying financial problem in their individual economies, to weaken their currency or to address any of the problems previously mentioned in this article.

Sweden

Sweden had negative interest rates from July 2009 until December 2019, when the country’s central bank deemed that negative interest rates were no longer necessary as a means to combat deflation in the Swedish economy.

The Riksbank – the central bank in Sweden – cut rates to below zero to reduce the dangers of the economic fallout of the 2008 financial crisis. However, after maintaining a 2% inflation target for more than two years from 2017 to 2019, as well as increased employment and overall economic growth, the bank decided to raise the rate from negative territory to 0%.

This was the first return to pre-negative interest rates for any economy that has implemented them in the fallout of the 2008 financial crisis. The decision was reached after four of the six members of the Riksbank board decided that to continue to implement negative interest rates might bring about slower economic growth which could start to hurt the Swedish economy in the long term.

The eurozone

The European Central Bank (ECB) has maintained a negative interest rate on deposits since 11 June 2014, which started at -0.10%. By 18 September 2019, the interest rate had fallen to a low of -0.50%. The ECB is a unique bank in the financial world, because the decisions it makes about interest rates affect the rates in the countries which use the euro as their main form of currency.

The negative interest rate policy of the ECB has largely been in response to the EU sovereign debt crisis, which first began in 2009 following the collapse of the global financial system in 2008.

The ECB decided to introduce negative interest rates as part of a stimulus package, which was aimed at fending off the risks of deflation in an economy that was already under strain. The ECB was given the task of ensuring price stability by having a target inflation rate of just below 2%.

The expectation is that eurozone inflation will remain considerably below this almost 2% target for some time, with the negative interest rates imposed by the ECB being an attempt to combat this.

Denmark

Danish interest rates have gone as low as -0.75%. In part, this has been to conform with the ECB’s monetary policy of controlling inflation, but also to keep the euro at an exchange rate within a 2.25% band above or below 7.46038 kroner.

Interest rates in Denmark are determined by the Danmarks Nationalbank – the central bank in Denmark, with the board of governors making decisions about whether to increase or decrease rates. As with other European countries, the fallout of the European debt crisis prompted the board to determine that negative interest rates were necessary to prevent an economic downturn in the Danish economy.

Danish commercial banks have different interest rate thresholds depending on the amount of capital in an account. For example, the Jyske Bank – the second-largest bank in Denmark – has previously charged -0.6% interest on deposits over 7.5 million Danish kroner. The bank has also charged -0.75% for all corporate deposits and private customers with deposits larger than 750,000 kroner.

Jyske Bank was also the first in the world to offer a negative interest rate on mortgage loans. The rate was fixed at -0.50% for ten years. Representatives of the bank stated that while it did not put money directly into the hands of borrowers, the negative mortgage rate did mean that every month, the outstanding debt is reduced by more than the amount borrowers currently pay.

Japan

Japan introduced negative interest rates in March 2016 to counteract the strengthening of the yen and deflation in the Japanese economy. The Bank of Japan (BoJ) thought this necessary because a strengthening yen would hurt Japan’s export-orientated economy.

The negative interest rates set by the BoJ are a measure to make the yen a less attractive investment compared to other currencies on the market. This is particularly true for those currencies that are often paired with the Japanese yen, such as the US dollar in the USD/JPY pair and the Australian dollar in the AUD/JPY pair.

While many in Japan are sceptical about the sustainability of the negative rates, the Japanese economy is still the third largest for an individual country in the world – behind the US and China in first and second respectively. Since Prime Minister Shinzo Abe’s election in 2012 and his implementation of loose monetary policy, the Japanese economy has grown, due perhaps in part to the negative interest rate policy of the BoJ.

Switzerland

Switzerland has one of the lowest interest rate policies of any country in the world, set at -0.75% for commercial banks who store their money with the central bank – the Swiss National Bank (SNB). This policy resulted in Swiss commercial banks paying almost £1.6 billion in negative rate charges in 2018.

However, the SNB only charges negative interest on deposits which exceed an exemption threshold. The exemption threshold can be changed at the discretion of the SNB, and in the past, it has been 20 times or 25 times the amount of a bank’s minimum reserves.

The exemption threshold is designed to help alleviate some of the strain that negative rates have had on some commercial and regional Swiss banks, as well as to stave off criticism from certain Swiss financial institutions. Perhaps the most vocal of these have been the Swiss Bankers Association, which stated that higher exemption thresholds are a welcome lifeline for regional banks in a negative interest rate economy.

What opportunities do negative interest rates offer traders?

Negative rates offer various opportunities to traders across a range of markets including forex, shares and bonds.

If rates are rumoured to be decreasing, traders might take out a short position on a particular currency in the expectation that it will weaken relative to other currencies that it is paired with. Alternatively, traders could take out long positions on the other currencies that a negative interest rate currency is popularly paired with to capitalise on the former strengthening against the latter.

Traders could also go short on banking stocks in negative interest rate economies, on the assumption that the banks will begin to feel the strain of narrower profit margins. Negative rates can also mean that traders go long on manufacturing or industrial stocks because there will likely be an increase in production within a negative interest rate economy.

Traders can also take a position on bonds during negative interest rates. With financial derivatives such as CFDs and spread bets, traders could stand to profit by speculating on the price of popular government bonds rising – or falling – in value during negative interest rates.

Negative interest rates summed up

• Negative interest rates are used as a last-ditch monetary policy in order to stimulate an economy by incentivising spending and penalising saving
• Negative rates mean that loans can often be repaid at a discount, and that central banks will charge a fee for storing money
• Some economists say that negative interest rates are unsustainable in the long term, and they can even damage the economic health of a country if banks tighten their lending policies
• Negative interest rates can sometimes be effective in helping a country prevent deflation and get back to healthy economic conditions, as was the case with Sweden