It seems that every year we enter new and uncharted territory when it comes to monetary policy. Quantitative easing, once presented by the Federal Reserve as an emergency stop-gap measure, has now become the new status quo. After a brief period of balance sheet reduction, 2019 has been a year of expansion, with some analysts predicting that the central bank will initiate QE4 before year-end (although it has arguably already begun).
With the Fed’s balance sheet having grown to truly enormous levels over the last decade-plus, many investors are now asking: What next? Central banks seem addicted to doing something rather than nothing, so a logical next port of call seems to be negative interest rates. Rates have already gone negative in Europe and Japan, so it does not seem out of the question that the same thing would happen in the United States.
Uncharted territory
Let me preface this by saying I do not know what will happen if the U.S. goes through a protracted period of negative interest rates - it truly is uncharted territory, so no one really knows what will happen. However, I do think it is productive to chart out a number of possible scenarios that could materialixe.
Further erosion of middle-class wealth
The last decade has seen an enormous expansion in asset prices, expanding the gap between the middle (and working) classes and the wealthy, due to the extremely relaxed monetary policy that has been implemented. Negative rates would be a continuation of this trend, and would punish those with cash savings (who have already been harmed by the drop in interest rates). The increasing attractiveness of debt will likely incentivize households to take out more loans to finance education, health care and personal expenditures.
Pressure on the banking system
Negative interest rates create a situation in which banks must pay to issue credit. Already low positive rates have compressed bank margins - this situation will only get worse with negative rates. This is arguably one of the reasons why the European banking sector has been underperforming. If banks start charging ordinary depositors to hold their money in checking accounts, it is unlikely they will want to hold their capital there, which will remove another pillar of support from the banking system.
Changes to company valuations
Typically, a company with a large debt load is seen as less valuable than a similar company with less debt (all other things being equal). This is in accord with common sense. However, what happens if the rate charged on that debt is negative? Does debt become an income-generating asset? Does this mean that companies with higher debt loads become more attractive to investors? I do not know the answers to these questions, but I don’t think I am being uniquely ignorant here. This brings me to the fourth consequence of negative rates.
Increased uncertainty
For the last 40 years or so, the "common knowledge" of the stock market has been that stocks always go up (in the long term). This common knowledge was based, at least in part, on the idea that money saved today will be worth more tomorrow. What does that common knowledge look like when money saved today will be worth less tomorrow? I think this shift will have profound implications, both political and economic, and could lead to much more volatile markets in the future.
Read more here:
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- Warren Buffett: Reading Will Make You a Better Investor
- ”‹Warren Buffett: Areas Don’t Make Opportunities, Brains Do
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