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The ABCs of negative interest rates and the impact on your portfolio

Richard Morin

Richard Morin

Update :
Update :
August 30, 2019

We've become accustomed to bank accounts that earn little or no interest, but would you accept that your bank charges you 0.6% per year to hold your money? That's what UBS, a major Swiss bank, is preparing to do for clients with deposits of more than 500,000 euros. It follows the lead of other Swiss banks that have already introduced negative interest rates.

Why pay the bank to hold our money?

The big Swiss banks are considered "risk-free", which attracts deposits from wealthy people seeking to protect their capital. However, these banks simply cannot lend out all the money deposited with them and thus generate the income to pay interest to depositors. The surplus is therefore invested in Swiss government bonds or kept at the Swiss National Bank, which charges a negative interest of 0.75%.

This phenomenon is part of a broader context in which central banks in a growing number of countries (including Japan, the European Central Bank, Switzerland, Sweden and Denmark) are "paying" negative interest on the deposits that commercial banks keep with them. They do this in the hope of forcing commercial banks to lend more money and thus revive economic growth.

Due in part to massive bond purchases by these same central banks, negative rates have spread to the bond market where over $16 trillion of bonds are trading at negative yields. To illustrate this phenomenon, the German government can borrow for the next 30 years without paying a penny of interest and even get paid for doing so!

All these efforts to generate more growth by lowering interest rates have had very limited success so far because central banks are facing a phenomenon that is beyond them.

Where does all this money come from?

Baby boomers and their pension funds have accumulated a lot of savings that they are looking to invest safely (especially with the big banks and in German bonds), even as economic growth is slowing. Less growth means fewer companies looking for capital and fewer investment opportunities. Too much money is chasing limited investment opportunities.

It is now understood that the slowdown in economic growth is also a phenomenon linked to demography. Growth in industrialized countries has been slowing down continuously for the past 50 years. While it regularly reached 6% until the mid-1970s, it has been barely 2% annually over the last decade. Over the same period, population growth in these same countries has fallen from about 1.4% annually to 0.5%.

In this context, the liquidity that central banks are injecting into the economy by lowering interest rates and buying bonds is more likely to create bubbles in the financial markets and in real estate than to actually accelerate growth.

A little intergenerational equity!

While central banks lack the tools, governments can act, while ensuring some intergenerational equity. The German government, for example, could borrow by issuing bonds maturing in 30 years - at the current rate of -0.15% - to finance infrastructure work - public transit, roads, bridges and so on. Funded primarily by the savings of baby boomers, this infrastructure would benefit generations X, Y and Z. As if the boomers were giving an interest-free loan to the next generations!

What about Canada?

Could negative rates cross the Atlantic and spread to Canada? It could. First, demographic trends are similar on both sides of the ocean. Second, if fears of a global recession materialize, the Bank of Canada will have to use the same tools as the European Central Bank - lowering the policy rate and buying bonds - with the same results. Then we will be the ones giving interest-free loans to our children!

Last week PIMCO - one of the world's largest bond managers - raised the possibility of negative interest rates in the United States. If this is the case, Canada will not escape.

What impact on our portfolio strategies?

To understand the impact on our portfolio, we need to remember that bond prices move inversely to interest rates. If the interest rate on 10-year bonds goes down, the price of the bonds in our portfolio will go up. For example, if the rate goes from 1.2% - which is currently the case - to zero, the price of the Canadian bonds we hold should increase by about 10%. Bonds are therefore an insurance policy that will limit the inevitable damage to the equity portfolio in the event of a recession.

That's why Archer continues to hold relatively long-dated bonds in its portfolios: they are the only ones that offer such protection. If, on the other hand, the economic outlook improves - as everyone but Donald Trump hopes it will! - the gains in our equity portfolio should more than offset the losses in bonds. We call this a balanced portfolio.

Have a good back to school!