Negative rates were tried for the first time in Sweden all the way back in 2009 as a temporary measure to keep their currency from strengthening. Now? Five different central banks have introduced the policy (Sweden brought it back in 2015) with rather uninspiring results, as well as some concerning externalities in areas like private sector debt and banking.
If the Fed is willing to lower rates three times in a year where GDP growth, employment, and the consumer continue to be robust and expanding, can you imagine what they’d do if we had an actual recession?
Analysis from the Geneva Report -- as presented by the Brookings Institution -- estimated that interest rates should have been lowered to -6% (!) during the trough of the Great Recession. The Brookings Institution is a near perfect lens into standard, generally accepted economic and policy interpretation of Congress, the Federal Reserve and established, safe political decision making. With almost half of foreign debt yielding negative rates and the most prominent think tanks in the world advocating for their use, you can bet that a -6% rate in a severe recession will likely translate to a negative 1-2% interest-rate range in a more garden-variety one.
Despite communication criticism directed at Jerome Powell, the Fed has been quite transparent about its intent. The rate increases and subsequent decreases it implemented last year and this year were priced in by markets and expected. If economic conditions deteriorate, I think that forthright messaging will remain and companies will be able to see negative rates coming well ahead of time. Here is how they may move around resources in such a scenario:
First, it’s necessary to understand the business of banking. Banks profit on the spread between the rates they pay to borrow and what they receive on their lending. Through a process of borrowing short term and lending longer term, they provide credit to businesses and individuals and keep healthy economies humming.
Banks should technically still be able to profit in a negative-rate landscape: borrowing at 4% and lending at 6% produces the same spread as borrowing at -.5% and lending at 1.5%. However, banks in negative-rate economies have refused, prudently, to pass on negative rates to retail deposits. Since the retail deposit rate is effectively floored at 0%, this has ramifications for banks that rely on deposits for funding.
Leading Up to Negative Rates
While banks haven’t passed on negative rates to retail accounts, they’ve been willing to do so for corporate ones. U.S. banks will preserve their spreads as much as possible by doing the same. I suspect this expectation will drive some unique corporate behavior as they attempt to reduce cash balances held in the U.S. to avoid potentially being charged to park their money at a bank.
The lion’s share of this activity will likely be done via stock buybacks and dividend increases. Companies are already buying back stock at a record rate, with over 50% of it facilitated via debt; I believe new records will be set, with the mode skewing much more towards cash. I’d anticipate an uptick in shareholder-friendly behavior for companies with substantial cash reserves such as Microsoft (MSFT) - Get Microsoft Corporation Report, Apple (AAPL) - Get Apple Inc. Report, Berkshire Hathaway (BRK.B) - Get Berkshire Hathaway Inc. Report, Facebook (FB) - Get Meta Platforms Inc. Report, Oracle (ORCL) - Get Oracle Corporation Report, Cisco (CSCO) - Get Cisco Systems Inc. Report, and Bristol-Myers (BMY) - Get Bristol-Myers Squibb Company Report as they look to reduce their cash balances. I’d anticipate a positive move for stocks to happen once the Fed’s intent is made clear. A basket of these symbols as rates are taken below zero should capture market outperformance.
Stocks should see a positive response as their expected returns become more favorable when compared with the falling yields from bonds. Falling interest rates mean cash flows generated by companies will have lower discount (risk-free) rates applied, making their present value worth more; this typically yields higher stock prices. There are more inputs to consider, but I think this “buy the news” rationale will prevail as markets prepare for the U.S. to introduce negative rates.
Once Negative Rates Arrive
Once established, I predict another shift in corporate behavior. I anticipate an increase in capital expenditures as net-present-value assessments used by companies to determine if an investment should be made are increasingly accepted, as investment returns exceed hurdle rates with interest rates so low. This in conjunction with unnaturally low costs of capital is a recipe for more spending and quite likely bubbles, as companies take on projects that in normal conditions would not make economic sense, while leveraging themselves to do so. Be on the lookout for companies whose debt-to-equity and current ratios increase materially in such an environment; these may be prime short targets.
As for banks and financials, in an effort to decrease their excess liquidity to avoid negative rates, European banks have significantly increased their lending to households and businesses. I would expect the same behavior in the U.S. Additionally, in a hunt for yield as their spreads are compressed, those European banks have also increased their willingness to make risky loans; with higher risk comes a higher yield, and a higher rate of default. For these reasons, in addition to the ones detailed in my previous research on financials, I’d stay far away. The broad underperformance of EU and Japanese banks on many fundamental metrics since the advent of negative rates has been impossible to ignore.
Lastly, to the previous point I made about discount rates and stock outperformance, I in no way would expect that to last. What will usher in negative U.S rates will be very weak growth or a recession; this means investors will eventually ascribe a higher risk premium to stocks, which will neutralize the benefit of a lower discount rate. Any sugar high experienced by falling rates will eventually confront economic reality. High-growth names with real cash flows, like the aforementioned group with large cash balances, will likely still be the place to be. Let’s hope we never have to navigate such a scenario.