You may have heard President Trump pressing the Fed toward setting negative interest rates something
the United States has never done.
It sounds far-fetched, but it's actually possible.
In fact, negative interest rate policy has been used by other countries in an attempt
to boost their economies.
Could the United States be next?
Let's take a look at what negative interest rates actually mean and how they may impact
your investments.
First, a quick reminder about how the Federal Reserve uses interest rates to manage the
economy.
When the Fed raises rates, it means higher costs on borrowing money, which means businesses
and people typically spend less.
This is done to cool down an overheated economy and keep inflation under control.
When the Fed lowers rates, it has the opposite effect: more spending.
The hope is that people borrow and invest more, jump-starting the economy.
For example, from 2008 through late 2015, during and after Great Recession, the Fed
even had its short-term benchmark interest rate near-zero percent to help the economy
recover.
But negative interest rates?
That's never happened in the United States.
It almost sounds impossible.
Lenders demanding compensation for the risk of giving money to borrowers is a basic principle
of finance.
But in theory, negative interest rate policy just takes the idea of traditional interest
rate cuts to an extreme: incentivize spending that boosts the economy by making holding
money unprofitable.
Here's how it works: One way banks make money is by keeping some of their extra holdings
in the central bank where they earn interest.
But under a negative interest rate policy, banks would be charged to store their deposits
of cash in the central bank.
The hope is that banks, losing money on their central bank reserves, would instead look
to make money by lending to more people and businesses, spurring economic expansion.
While boosting economic growth is the goal, not everyone is convinced negative interest
rates are a good idea.
Some experts believe that since lower interest rates could make lending less profitable banks
may actually reduce lending.
Banks that are squeezed could even pass fees on to their customers or charge them to hold
their deposits.
Some economists also fear that the bond market may take a hit and that investors looking
for higher yield could create bubbles on the stock market or in real estate.
There's also the fear that negative interest rates could lead to runaway inflation.
But we don't have to just speculate about what negative interest rate policy would look
like in practice.
We can look to Europe and Japan for clues.
The European central bank instituted negative interest rates in 2014.
Japan did the same in 2016.
It hasn't been the fix those banks were hoping for.
Economic growth as measured by gross domestic product, or GDP, in Europe rose 2% in 2016,
2.4% in 2017, 1.8% in 2018, and 1.2% in 2019.
In Japan growth was 0.6% in 2016, 1.9% in 2017, 0.8% in 2018 and is forecast to be down
to 0.5% in 2019.
It's important to note that many factors impact GDP, and stunted growth may not be
completely or directly attributable to negative interest rates alone.
And none of the central banks that have instituted negative interest rates since the Great Recession
have been able to jump-start enough growth to grow out of negative interest rates.
As one financial executive based in Berlin told The Wall Street Journal, overall we
are on a painkiller, and it's very hard to get off it.
Finally, according to a study by the University of Bath, bank lending has dipped in Europe
and Japan, though we haven't seen the runaway inflation that some feared.
What could negative interest rates in the United States mean for investors?
First off, safe-haven Treasuries would have little to no yield.
The same with investment-grade corporate bonds.
You can also expect that the Financials sector of the stock market would take a hit.
Money could flow into lower risk stocks like utilities and consumer staples as well as
REITs and longer-dated Treasuries that may have higher yields.
People may also diversify by purchasing physical assets like gold or real estate.
We don't know if negative rates will ever be instituted in the United States, but it's
a possibility and investors should prepare.