The Conundrum of Negative Interest Rates: Generating Income and Return in an Unprecedented Era for Fixed Income

Negative interest rates have posed a conundrum for the global economy and the financial markets over the past.  They have provided economic stimulus and support since the Global Financial Crisis (GFC) but have upended our previous understanding of economics.  The Covid-19 pandemic and the monetary and fiscal support necessary to offset its impact has increased the incidence of negative interest rates but even before the onset of the pandemic, interest rates in Japan and parts of Europe were at, or below, zero for many years.

The consequences of negative interest rates for economies and investors are dramatic, not least because they have made it all but impossible for fixed income investors to offset long-term liabilities and generate income from investment grade government and corporate debt.  Unlimited liquidity and government borrowing should lead to growth but also to inflation and to higher nominal if not real interest rates, but have not so far.

Charlie Munger, the famed investor, has said that if you are not confused about negative interest rates, you are probably not thinking about it correctly.  We do not purport to understand them but have to navigate them nonetheless. 

In this insight we explore the impact negative interest rates have on companies and the consequences for investors. First, however, we think it is important to understand how we got to this point.

The path to low /negative interest rates

The current low, and in many cases negative, rate environment is primarily the result of monetary policy and quantitative easing (QE) measures, designed by central banks to stimulate economies after the GFC  in 2008-09. The policies were expected to force banks to lend to businesses and consumers and to act as a tool to depreciate currencies and to encourage trade, particularly in open economies where trade is a big component of GDP. The prospect of a global recession induced by the recent Covid-19 pandemic has prompted another wave of policy measures with the same intended impact.

Central bank actions have given rise to a pattern that has become apparent over the past decades:  sharp rate cuts each time there is a recession, followed by more gradual tightening cycles, each one less pronounced than the last. Take the US, for instance, where the Federal Reserve Bank rate reached 2.5% in 2019, half of what it was in 2007 and almost a third of what it was at its peak in 2000. Meanwhile, Bank of Japan rates have been extremely low throughout this period, with negative rates first announced in 2016 as Japan tried to promote real economic prosperity.

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