Vanguard leaders discuss the impact negative rates have on investors

How do negative interest rates work? Vanguard Chief European Economist Peter Westaway and Jonathan Lemco of Vanguard Investment Strategy Group discuss the impact negative rates have on investors.


Rebecca Katz: There’s quite a few questions from our viewers about negative interest rates. And, quite honestly, before we went on air, you were trying to explain to me how you could have negative interest rates and how someone would buy a bond that has a negative interest rate. So maybe give us a little bit of background about where and how are interest rates going negative in some of these countries and what the implications of that are because we have Connie in Washington and Eric in Virginia both saying, “How should I think about international bonds in light of negative rates?”

Peter Westaway: Yes. Well, I mean negative interest rates are just one part of the armory that central banks have in order to provide stimulus to the economy. So I mean you start off, an economy goes into a downturn, central banks will cut interest rates. They cut interest rates until they hit the floor, which people used to think was zero. The next thing they’ve done is they’ve indulged in quantitative easing, which is effectively money printing to provide liquidity into the economy boosting asset prices providing spending power. But when that doesn’t work, they’re then looking around for something additional. And so the next step has been to cut interest rates. Not just to zero but below zero. Now there’s only a limited extent to which you can do that because at the end of the day, people have always got the option of taking out cash in terms of bank notes. And so if your bank is offering you negative interest rates, why on earth would you put your money into the bank?

Rebecca Katz: But isn’t that the idea?

Peter Westaway: No, not really. In practice what’s supposed to happen is banks start offering lower interest rates on deposits, even negative interest rates on deposits, and that will allow them to bring down their lending rates as well so that people will be able to borrow money more cheaply. The problem is that in practice very few commercial banks are willing to cut interest rates into negative territory. So what you end up having is the only people that are having to pay you a negative interest rate are the banks themselves when they deposit their funds in the central bank. So it’s starting to eat into their profitability and banks are starting to really suffer.

Rebecca Katz: Profits.

Peter Westaway: So in the euro area, in Japan, they’re sort of squealing, to be honest. And so I think even though there’s a lot of publicity around it and it sort of, as you say, is sort of jaw dropping and how unusual it is, but I don’t really think this is going to be the measure that’s going to really make the difference for these economies.

Rebecca Katz: Well, it’s interesting because you mentioned that this is just one tool in the arsenal. And the U.S. used some of these other tools, quantitative easing and buying back bonds. It seemed to work. We have a question from Bert, who said, “That worked in the U.S. It improved,” and his definition of “worked” is it improved stock market performance. We have not seen the same effect in Europe. So when you talk about these things working, what is the goal, the end goal? Is it stock performance?

Peter Westaway: That’s one of them because I think that’s been one of the ways in—and I agree with that presumption that both in the U.S. and I think in the U.K. by providing a boost to not just stocks but risky assets more generally because you effectively buy one set of assets so people are then going to go away and buy some others and they bid up their prices. That worked for us in the U.K. It worked here in the U.S. But the European economy works in a rather different way. The banks rather than capital markets, the banks are absolutely central to how things work. And because the banks are still effectively a bit broken since the sovereign crisis, that money isn’t flowing into the system in the way that I think policymakers want. So, I mean I think we have seen a bit of an effect on the stock market prices in Europe, but probably not quite as strong. And so that’s why really there’s still a big question mark in the euro area about whether or not these measures are going to work. I mean they’ve brought down yields, and that’s a really important thing. You know, remember, sovereign yields in countries like Italy and Spain were up around 7, 8, 9%. These countries are on the brink of not being able to finance themselves. So certainly the effect that QE has had the effect of pushing down yields. But whether it’s really got demand moving as strongly is much less clear.

Jonathan Lemco: It’s very unclear. And, again, a big motive, as Peter has said, the stock market is very important, but can we get banks to lend and in turn promote economic growth? And the jury is totally out on this. This is, to me, something of an almost desperate measure, but we’ll see. It’s almost unfathomable to think that you lend monies or you give money to the bank and in turn get something less down the road. But it’s a tool that they choose to use right now in an effort to try and spur the economy in different ways. And we’ll see.

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