Vanguard’s economists discuss the impact of negative rates


Some central banks, including the ECB and the Bank of Japan, have adopted negative interest rates in further attempts to promote economic growth. But are these attempts working and what effect do they have on investors across the globe? Vanguard Global Chief Economist Joe Davis, Senior Economist Roger Aliaga-Díaz, and Senior Investment Analyst Andrew Patterson examine how far monetary policy can or should go and what investors can expect going forward.

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TRANSCRIPT

Vanguard Perspectives® Noni Robinson: Some central banks have adopted negative interest rates, notably the ECB and Bank of Japan. What are the investment implications of this?

Roger Aliaga-Díaz: Yes, Noni, that’s a great question. Actually, a little bit over one-third of the global market cap in the bond universe is under water in those other markets with negative rates. But interestingly, the foreign investors that are home-based in countries with rates that are non-negative—here’s a counterintuitive take on it. Investing in international bonds with negative yields doesn’t lock U.S. investors into negative rates. And the reason for that is that when you invest in international bonds, you have to factor in the currency that it takes basically to bring back that yield into your home currency, and in this case, into U.S. dollars. The same for Australian investors into Aussie dollars. It’s the fundamentals of economics, this relationship between rates and currencies, they tend to offset each other. The more negative the yields are, the more the currency is expected to move in a direction to exactly offset and bring yields in parity with the U.S. Treasury, in this case. Otherwise it would be creating inflows and arbitrage relationships. So the bottom line is investors should expect ex-ante yields that will be positive, adjusted for the currency. That’s not to say that investors don’t get negative returns from a bond, the same way as in U.S. Treasuries or in a German bond or a Japanese in government bond. That depends on how rates move and the different shocks to the economy. But the diversification benefits, for the very same reasons, are still there even for those investing in international bonds.

Noni Robinson: Andrew, one of the questions we often hear from clients is, “Do you think we will experience negative rates here in the U.S.?” What are your thoughts?

Andrew Patterson: So, I think the Fed would love to avoid negative rates at all costs. Whether they’re going to be able to, we can’t say one way or the other with absolute certainty. There are just too many other factors at play. What we have now is really a case study in Europe and Japan on the implications of negative interest rates. And it seems like to date, things are not playing out as policy makers may have hoped. You’re not seeing the pickup in investment; you’re not seeing a pickup in household leverage and the spending that that may induce. So, you’re just not seeing the uptick that you may have hoped that would help drive their economies forward. In terms of the U.S., I think they’re on much surer footing than our developed market compatriots. You relatively strong growth in the U.S., around 2%; you have a labor market that’s approaching full employment; and you have inflation—by whatever measure, whether it’s CPI, PCE—moving closer to that 2% target that the Fed has set for itself. That said, I think really the only way that the Fed is able to avoid negative interest rates considering where rates are today, is if the U.S. economy is able to avoid a recession. And economists are historically less than accurate about predicting recessions and when those might pop up. So, in all likelihood, we will be able to avoid it but we can’t say with absolute certainty.

Joe Davis: You know, clearly, the Federal Reserve will try to avoid that. And we are in much better shape fundamentally, the labor market-, economic performance-wise than [the economies of] ECB, Bank of Japan, and a few other central banks that have pursued negative interest rates, which unsurprisingly hasn’t gained much traction because the world had too much leverage before the GFC [global financial crisis] and now, hoping for certain institutions to take on greater leverage in order to stimulate growth, I think is misplaced. So, I don’t think we’ll see it from the Federal Reserve, but we could see long-term interest rates potentially drop below zero. I think it goes to [show], on a cyclical basis, that growth, relative to pre-financial crisis, [that the] lower the growth rates, the [higher the] demand for high quality investment-grade assets. That demand continues to rise and so, the relative value of U.S. Treasuries securities, despite our level of debt in a highly indebted world, ironically that demand continues to increase because [these investments] continue to show [the] ability to diversify portfolios and Treasury bond prices tend to rise when stock prices are tending to fall. So, I don’t see that demand, in the near-term, changing in a world which, at the margin, [is] aging and potentially becoming a little bit more conservative. That’s a tailwind for the demand for high quality fixed income. And ironically, in a highly indebted world, we actually have, you could argue, would love [to see what] we’re about to see, [which is] more high-quality debt, in terms of being able to invest in areas such as the U.S., [or in] reserve currency of the world and in deep bond markets. So, we’ve talked about this on and off for three or four years. So again, negative interest rates in the U.S. [is] clearly not our baseline, but should something happen, unfortunately, in the global economy, that would even tip the U.S. economy into recession, that demand for high-quality fixed income assets in my mind, would only drastically increase.

Important information All investing is subject to risk, including the possible loss of the money you invest. Investments in stocks issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. Diversification does not ensure a profit or protect against a loss. © 2016 The Vanguard Group, Inc. All rights reserved.