The European Central Bank contemplating negative interest rates as one of its policy tools to kick start the moribund Eurozone economies. 

I’ve had a number of questions about the concept of negative interest rates and thought it best if I reproduce an article I wrote for Business Spectator in 2012 on the topic.

The link is here 

The full story is below.

Negative interest rates – how, why and for how long?

Two-year government bond yields in Germany are minus 0.05 per cent. In Switzerland, the yield is minus 0.36 per cent. Negative interest rates in the government bond market have also been seen in Denmark, the Netherlands, Finland and Austria.

One side effect or hangover from the global financial crisis is low interest rates. Not just a little bit low, but all-time lows, are being reached on government bonds yields around much of the world. This is occurring at the same time that official interest rates being set by central bank policy makers are also near zero as they pump their economies with cheap and easy money and try to engineer some form of sustainable economic recovery.

These record low interest rates from both the bond market and central banks are a proper and natural reaction to chronically weak economic growth, mass unemployment and disinflation.

Who would have thought just a few years ago that 10-year yields in the US and UK would fall below 1.50 per cent? The Australian bond market has even joined the party with its 2-year yields dropping below 2 per cent a few weeks ago.

What is even more eye-popping is the recent trend towards negative short-term (three months’ to three years’ duration) interest rates for government bonds.

That’s right – negative interest rates.

The concept of negative interest rates is a real brain teaser. Economics text books do not mention them, let alone analyse the consequences of such a market move. 

Intuitively, one would judge that lenders must receive a positive return (interest) to lend their money to a borrower, and the borrower must pay (interest) for the privilege of holding and using that money. 

It’s as though you are going to hire a car and not only do you get the car to drive around for free, but the car hire company gives you $50 because you are a good, reliable and low risk customer and they know or assume you will return the car in good shape and on time. Substitute ‘money’ for ‘car’ and that is what is happening in some bond markets.

Negative interest rates mean the lender – in this instance a bank or a fund manager – is agreeing to forgo some of the principal to hold the paper issued by the government. One reason they do this is because they have a high level of confidence the remaining 99.5 per cent or so of the principal will be repaid. With positive interest rates, the lender would get back 100.5 per cent of the principal at the maturity of the loan. 

Another reason why negative interest rates are becoming more widespread is because banks and other investors see no alternative credit worthy investments. If there were low risk and credit worthy alternatives, the money would be allocated to those markets rather than being locked up with slowly eroding value due to negative yields. 

This fact only reinforces the sad state of affairs in the global economy.

There is also the question of how negative interest rates actually occur. Surely it would be better just to hold cash? At least a €10 note is worth €10 in two years’ time, unlike a negative interest rate bond which will be worth less than €10 when it matures. 

The proposition of holding physical cash falls down when the size of the market involved is considered. The fund managers and banks have tens of billions of euros and francs to invest. They cannot physically hold the notes and coins in cash and they do not want to place their money with a bank for fear that the counterparty bank will default. That’s when you lose 100 per cent of your money. When the funds are allocated to the safe-haven of government bonds, the interest rate is pushed lower and lower until it goes negative. It is as simple as that.

There is one other potential reason for negative bond yields: a fear of deflation. If economic conditions are so bad that enough of the corporate and household sector believes the economy is set for deflation – that is, a period of falling prices – they will hoard their cash in anticipation of greater purchasing power at some time in the future when prices fall. This is another worrying aspect of negative yields.

So how long will these countries have negative yields? Can they fall yet further? 

While the world economy is in such a deep funk and with little prospect of a sustained pick-up, yields can stay very low. Just because negative yields are odd at the moment, it doesn’t mean investors can’t get used to them. This point is only reinforced in a world where investment risk is so acute.