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Negative interest rates: What you need to know

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By Adam Baley

Negative interest rates were little more than an academic curiosity until recently when some of the world’s most powerful central banks made negative rates part of their monetary policy.

Just as they sound, negative interest rates require depositors to pay banks to hold their money. Negative rates challenge a fundamental assumption of financial systems – that when you lend someone money, they have to pay you.

For now, at least, negative rates exist primarily on an institutional level. They directly affect large commercial banks and other institutions keeping excess reserves at central banks that are charging a negative rate. Those central banks include the Bank of Japan, the European Central Bank and their counterparts in Denmark, Sweden and Switzerland.

By charging institutions to warehouse their money, the central banks hope to spur economic growth. Both the negative rates overseas and the low rates in the U.S. are designed to push cash out of the banking system and into the hands of companies and consumers who will spend it.

Negative rates should remain an overseas matter. In her testimony before Congress in February, Fed Chair Janet Yellen cited possible legal hurdles to negative rates in the U.S. Given the strength of the U.S. economy, negative rates remain a remote possibility here.

Consequences for investors

In the short term, negative rates should reduce the profitability of affected commercial banks. They have had ripple effects beyond banks. Japan recently issued a 10-year bond with a negative rate, the same with a corporate bond in Switzerland.

Negative rates should weaken the currency of the countries that have gone negative, which means investors should plan for the U.S. dollar to maintain its relative strength. That could continue dampening effects on U.S. companies trying to sell abroad.

Also, negative rates overseas encourage global investors to own U.S. bonds, especially as the Fed proceeds to gradually raise rates. As a result, look for the yield on the 10-year U.S. Treasury note to remain stubbornly low.

In the medium term, negative rates are intended to kick-start economic momentum overseas and ultimately give way to normal monetary policy. The old school method of restarting an economy is to weaken the currency, making products, services and labor more attractive. Give it time, though. Economists talk about the time lag – often cited as 12-18 months – between monetary policy changes and the first signs of results in the broader economy.

No one can say with certainty what effects negative rates would have if they persist in the long term. The financial system is not built to accommodate prolonged negative rates; overuse could cause economic distortions, raise questions of the viability of the banking industry and even alter how individuals think about saving and spending.

Because negative interest rates have been mostly theoretical until recently, expect central banks to be watching them closely. If they see the strategy doing more harm than good, they can reverse course and pursue more orthodox methods.

For now, consider negative interest rates a new banking tool. Preliminary indications suggest minimal impact on investors, but we shall monitor any long-term effect of such an unusual monetary policy.

In the meantime, investors have a tried-and-true approach to deal with uncertainty: A balanced investment portfolio. A balanced strategy offers long-term investors the courage and confidence to withstand the unexpected – including the effects of short-term monetary changes.

Adam Baley is a registered representative and investment advisor at Landaas & Company.

(initially posted March 31, 2016)

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