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6 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff discusses what negative interest rate policy means for retail bank customers and the recent plummeting of government bond yields into negative territory.
WILL BANK CUSTOMERS BE CHARGED NEGATIVE INTEREST RATES?
Central bank policy aside, one of the public concerns about negative interest rates is that banks will begin passing on their negative rate losses (charged by the central bank) to their customers in the form of negative rates on deposit balances.
There have been reports of banks in Europe charging more fees on account balances for very wealthy clients or even calling them negative rates, but the preponderance among average retail customers has been very low. Banks can still recoup most of their negative rate losses by tying free checking to other, more profitable financial services, trying to make up the losses with additional fees, simply lending more as the central banks want them to, or buying securities that produce a higher yield than the central bank’s negative rate.
But the greatest reason that banks are reluctant/slow to enact widespread negative rates on their customers is cash withdrawals. Depositors always have the option of avoiding those negative rates by withdrawing their money in the form of cash and stuffing it under the mattress.
Cash has a yield of zero which is a lot better than -1%. So both banks and the policymakers pressuring them know that pushing negative rates too hard on retail customers could backfire, badly. So much cash could be pulled out of the system that the broader money supply contracts and the policy produces deflation and less lending—the precise opposite of its stated objective.
(the Economics Correspondent will write in more detail soon about the cash option and so-called “war on cash” that many central banks and governments are drawing up to counter the cash withdrawal option)
Instead of small retail depositors, large commercial customers and wealthy individuals are more likely to be the first negative rate target of commercial banks since a major corporation holding, say… $500 million in a deposit account, is less able to convert its balance to cash than the average retail customer.
For a corporation, holding $500 million in physical cash is complicated and risky. It’s difficult to pay all the bills to suppliers, vendors, creditors, and employees using cash. It’s also dangerous and expensive to store that much cash in a vault or a room.
So banks, central banks, and policy makers know that in theory they could get away with a mild negative rate on very large balances since the costs of withdrawing cash and storing it, plus risks, would be greater than simply eating a modest negative rate of -0.1%.
Also, pushing negative rates on large corporate customers and wealthy individuals is easier to sell politically. After all, corporations and the wealthy have committed the sin of making and having a lot of money. Plus politicians can easily validate the policy by blaming both scapegoats for the sluggish economy because "they aren't doing their part to vigorously invest and spend their cash hoards on jobs.”
But once the public sees negative interest rates adopted as a widely accepted practice on large commercial and individual balances, they should worry. One of the necessary preconditions to moving on to smaller retail balances (the other being abolishing high denomination notes, as the 500 euro note has already been discontinued) will have been cleared and everyday retail bank customers will be closer to entering policymakers' crosshairs.
WILL BANKS START PAYING ME TO BORROW MONEY?
Some news articles have gone so far as to suggest current negative interest rate policy already means “banks will pay you interest to borrow.” And a handful of loan rates in Europe have been noisily reported as going negative. For example, very short-term mortgage rates (less than five years) in Denmark have gone slightly negative. However when factoring in processing fees that the lenders charge the effective rate is still slightly positive.
For the average retail customer being paid to borrow is highly unlikely although I wouldn’t rule it out completely in the long term. If central banks push negative rates down far enough, a bank could theoretically be willing to take a loss on a retail loan if the loss is smaller than letting its excess reserves sit idle and earn an even worse negative rate.
For example, if (heaven forbid) central banks ever charge member banks a more extreme negative rate of -3% on idle excess reserve balances, and a commercial bank was having trouble finding enough borrowers on 1% loan rates, it might consider lending at -0.5% since losing 0.5% a year plus charging processing fees is a lot more attractive than losing 3% a year.
However credit risk is still a major factor. A bank leaving its reserves idle eats a negative interest rate but it’s guaranteed to lose no more. Lending at a -0.5% rate might seem like a better deal, but if the borrower is a credit risk then the prospect of losing 25% or 50%, or all of the principal in a default might deter the bank from making the loan anyway.
In any event, the negative rates central banks are charging their member banks in Europe and Japan are hardly low enough to warrant widespread retail lending at negative yields. And in the United States, where the Fed is paying positive interest rates—approximately +1.8% on excess reserves at the time of this writing—the prospects of Americans being paid to borrow money are very remote (exception: Uncle Sam).
THE CURRENT SOVEREIGN DEBT PHENOMENON
However, paying someone to borrow is precisely what commercial banks in Europe have been doing… just not with their retail customers, but government debt instruments.
There's been a lot written recently about European government debt yields going negative and predictions that it may be coming to the United States soon.
In light of central bank negative rate policy it becomes easy to understand why. If a European commercial bank is paying a -0.5% rate on excess reserves to the ECB, yet it feels its pool of available borrowers is too risky to lend to at 1% or 0%, then it sees investment grade government debt (meaning not Greece), even slightly negative yielding debt, as a better alternative.
Given the bad choices of paying -0.5% to the ECB, or lending to risky borrowers, European banks probably view German government Bundesbonds as a good alternative. Yet with other European banks also chasing German bonds—in addition to central banks which are already engaged in large scale government bond purchases—the inflated demand can push the bond's market price above the principal or face value, drive the effective yield below zero, and banks will still buy it.
Click link to read Wall Street Journal column on "Germany for First Time Sells 30-Year Bonds Offering Negative Yields"
Here’s a mathematical example using dollars instead of euros for simplification: A European bank might buy a two-year bond with a principal/face value of $10,000 and pay $10,420. Even though the bond pays a 2% coupon ($200 a year for two years or $400 which is a 2% rate), the bank ultimately only gets $400 in interest plus the $10,000 redemption for a total of $10,400. Since the bank paid $10,420 it loses $20 on the entire transaction or an effective yield of approximately -0.1%.
But losing 0.1% on a very safe debt instrument is better than losing 0.5% to the ECB, or losing 100% of the loan principal on a retail or risky commercial borrower who defaults.
Furthermore, the phenomenon of central banks plus commercial banks scrambling to buy whatever government debt they can find has led to a new and novel bout of bond speculation. Enter peripheral players: pension funds, insurers, and institutional investors who can plainly see the trend of central banks pushing negative rates lower and lower. And they are also buying negative-yielding government debt, not for the negative yield, but rather in the hope that they can sell it at an even higher price later… the equivalent of bubble-era house flipping, only this time with government bonds.
This is the screwy world that occurs when central banks go negative enough.
For a list of negative yielding bonds by country click this link.
It’s no coincidence that all negative yielding countries are either European or Japan as the ECB and BOJ are the prime instigators of negative rate policy, along with the Swedish Riksbank, Swiss National Bank, and the Danmarks Nationalbank.
With yields in Japan and Europe going more and more negative, banks are looking elsewhere for safe instruments and demand for U.S. Treasuries, already extremely popular even before negative interest rate policy began due to the U.S. dollar’s global reserve currency status, is rising.
Although the Federal Reserve isn’t engaged in negative rate policy on excess reserves, the consequences of negative rate policy in Europe and Japan are spreading to American shores. The prospects of this trend continuing is what has prompted market observers and even Alan Greenspan to predict that negative yields on U.S. Treasuries are an inevitability.
And this would of course please no one more than the U.S. government: both Congress and President Donald Trump (or any other president for that matter). What politician wouldn’t savor the idea of being able to borrow and deficit spend even more with less consequence? Imagine being able to borrow a trillion dollars to spend on buying votes and only having to pay back $980 billion ten years later!
Which presents another possible unintended and worrisome consequence: negative rate policy may encourage a new chapter of bloated government debt rising far beyond even the indefensible levels already prevalent in developed countries. Imagine giving more liquor to an alcoholic but this time paying him to drink it. The outcome is not likely to be good.
Of course one cynical view could be that negative government bond yields facilitating even more borrowing is a feature, not a bug, of negative rate policy. The Economics Correspondent, himself never a fan of central banks and their symbiotic relationship with governments, is very open to that theory, especially considering policymakers’ sincere but misguided belief that their negative rate policy is beneficial to the economy. If you think you’re both stimulating the economy while providing cheap financing to the very government that grants you a legal monopoly on currency and reserves issuance, how can you not view the result as a win-win?
In Part 3 we’ll take a close look at the so-called “war on cash” and see what strategies elite policymakers are already drumming up to force retail bank customers to eat negative interest rates on their deposits one day.