Run the Red; Run the Risk – How negative interest rates turn economies on their heads.
If you have a home loan or a term deposit, then it is likely that you also have some level of curiosity around what is going on with interest rates.
Each month, the Reserve Bank of Australia (RBA) meets and sets the interest rate. Currently, it’s set at 2%. If the RBA decides to increase interest rates, it is likely your mortgage will also increase, although on the upside, so will term deposit rates; equally, if the RBA drops interest rates, your mortgage repayments will drop—but so too will interest earned from your term deposits.
Like the RBA, the central reserve banks in other countries use interest rates to stimulate or slow their economies. In simple terms, they drop interest rates to stimulate economic activity when things get too ‘hot’, and they increase interest rates to cool them down. Oftentimes, though, the reaction times are a little too slow, which causes things to go off the rails, resulting in the boom-bust cycle continuing ad nauseum.
Now, consider what would happen here if RBA interest rates became negative. What would be the impact on cash in the bank, lending, and other areas of the economy?
Today, Japan, Sweden, Switzerland, and the Euro zone all have negative interest rates (to varying degrees).
If you placed your money into a bank account in Europe right now, it’s highly likely you would be actually charged interest for putting money in the bank. That’s right—you would not be earning interest; instead, you would be charged a fee for depositing the money! In the long term, of course, this really hurts savers and retirees.
Conversely, in some cases if you have a loan with a bank in Europe, the bank will pay your mortgage for having this debt drawn down. Other loans are simply dished out at a very low interest rate, such as 1–2% p.a. Naturally, this encourages people to take on debt at levels far greater than when interest rates are at normal levels.
You can see that very odd things start to happen in the long-term as this topsy-turvy situation plays out.
Other areas of the economy also become distorted. If there is a trade surplus position like Japan, which means they export more than they import, then negative interest rates could end up pushing the currency up against, say, the US dollar.
On the other hand, if there is a trade deficit, the currency can depreciate—like the British pound did against the US dollar. This all has to do with the need for funding and attracting overseas investment to fund the shortfall. In Australia, if we ever went negative, we would almost certainly suffer a similar fate to the UK.
The hope is that in the long term, these economies will normalise and interest rates will return to a more normal level. However, if the market continues to price in negative interest rates for Japan and Switzerland for at least the next 10 years, this phenomenon might be around longer than we think.
So, if you see some strange things happening abroad, remember it might relate to the negative interest rate environments these countries are currently enduring, and bear in mind that one day, their interest rates will likely normalise.
Please also remember that before embarking on any investment decision, you should always seek professional guidance from a licensed financial planner. Of course, I recommend AJ Financial Planning.