Most economists are tempted to rely on incremental analysis to explain the spread of negative interest rates and their implications for the global economy and markets. This is understandable, yet the inclination to focus primarily on marginal changes could be overly partial and even misleading â€” especially for market participants who must navigate the unintended consequences of sub-zero yields, including the possibility of â€œtippingâ€ events.
The conventional argument of economists goes something like this: The actions of central banks and the market pricing of government bond yields have proved that zero no longer constitutes a lower nominal bound for interest rates. As a result, the effects of negative rates are best analyzed in terms of deltas â€” that is to say, by extrapolating the marginal impact of a change in rates (say from minus 0.2 percent to minus 0.3 percent), as opposed to assessing levels as a whole (how negative and for how long). Despite the historical anomaly of negative nominal rates, most economists are inclined to apply the traditional analysis of a continuum of pricing, behaviours and economic effects.
I am not so sure that this necessarily is the right approach. Three developments on the ground support this skepticism and suggest the need for more open thinking and analysis:
First, much of the institutional setup for providing financial services to millions in systemically important advanced economies was not designed to operate for long with negative nominal interest rates, and with the associated flattening of the yield curve. For example, with pressures on net interest margins, banks face greater challenges in intermediating funds and are increasingly inclined to turn away deposits. Moreover, providers of long-term financial savings, protection and assurances â€” from pension funds to insurance companies â€” find it harder to meet client expectations of meaningful safe returns many years in the future. There are no meaningful substitutes available in the short-term.
Second, persistent negative interest rates may compel a growing number of individuals to disengage from a financial system that now taxes them for placing deposits and savings. No wonder the sales of home safes soared in Japan after the Bank of Japan unexpectedly decided to follow the European Central Bank into negative policy rate terrain.
The longer these two sets of circumstances prevail, the greater the pressure on individuals and companies to self-insure rather than rely on the systemâ€™s collective insurance facilities. In turn, that risks translating into slower economic activity, as well as more fragmented financial markets that are harder to monitor, influence and regulate.
Third, if negative interest rates go beyond perceived thresholds of reasonableness and sustainability, the operating modalities of certain markets could change. This dynamic may be playing out in the recent puzzling behaviour of foreign-exchange markets after both the Bank of Japan and the ECB adopted and reinforced their negative rates policy.
Rather than depreciate, both the yen and the euro have appreciated. Although some of these counterintuitive moves reflect a somewhat more dovish Federal Reserve, which has mitigated expectations of highly divergent interest rates among the world’s central banks, there could well be something bigger in play: Specifically, the dilution of interest-rate differentials as the main driver of currency values, particularly as greater attention is paid to stock effects, including the ability of citizens to repatriate capital from abroad. This is an especial concern for Japan.
All this calls for further analysis and more open- mindedness from economists when assessing how the global economic and financial system is likely to operate now that about one-third of global government debt is trading at negative nominal yields. Specifically, stock effects and behavioral influences could alter the conclusions that are derived from an analysis based primarily on interest-rate differentials and other relative pricing considerations.
Should this prove to be the case, and I suspect it will, the implications for investors and traders would go well beyond the potential of a new set of unintended and unusual potential headwinds to economic growth and corporate earnings. The new understanding would require altering pricing models for foreign- exchange markets, recasting assumptions about correlations among different asset classes, being more open to the possibility of sudden market jumps and air pockets, and factoring in a larger liquidity risk premium.
Mohamed El-Erian is a Bloomberg view columnist and is also the chief economic adviser at Allianz SE. His new book is â€œThe Only Game in Town: Central Banks, Instability and Avoiding the Next Collapseâ€