Impact of Negative Interest Rates on Equity/Fixed Income markets

Negative Interest Rates

Potential Impact on Equity Valuations / Fixed Income markets

Negative Interest rates – Rising importance in today’s economy

Background

Since the global financial crisis in 2008, central banks have cut benchmark interest rates around the world to provide loans at a cheaper rate for stimulating economies. Fast track to 2016, the world witnessed central banks of countries such as Sweden, Japan, Switzerland and Denmark opting for negative interest rates. Although, in theory, this should stimulate economic growth. However, these economies witnessed a weak growth in inflation with Japan still fighting deflation from the past two decades.

Figure 1: Bond Yields vs Stock market indices return during the phase of negative interest rates

Source: Yahoo Finance and Eikon Database

COVID-19 and its role in Negative Interest rates

COVID-19 further contributed to already slowing down of world economy. A decline in interest rates generally stimulates growth. But what if the rates are already near 0.25%? The central banks have no other option but to push rates into negative territory.

Governments started buying bonds heavily to lower the bond yields through quantitative easing. Decline in yields will force investors towards equity market for high dividend paying stocks. Negative interest rates also force commercial banks to lend loans to business, rather than depositing the excess funds with central banks to avoid payment for this service. This in turn aids in achieving targeted inflation. However, quantitative easing will depreciate currency due to its excess supply.

Implications of negative interest rates on Banks

Bank’s net interest margins will take a hit. Banks have to scrutinize businesses/individuals in terms of loan repayment and their distance to default. Though banks will incur certain costs arising due to deposits with central banks, they will find it difficult to push these costs on to depositors, who may redeem cash and leave banks with less amount to lend out loans to businesses.

Potential impact on Fixed Income markets

Mutual Funds and Pension Funds are at a disadvantage as they invest money in government bonds yielding negative returns. However, on the flip side, corporate bonds bought at discount and if held till maturity results in capital gains. They also provide higher coupon payments as these bonds are derived based on asset quality of the companies.

Potential impact on Equity Valuations

Yes, equity markets are at an advantage as companies obtain loans at a cheaper rate to spend on capex for organic growth or on acquisitions for inorganic growth.

However, in case of share buyback, the share price goes up due to less outstanding shares. This act increases Price-to-earnings ratio. This valuation is not entirely accurate as the company’s share price didn’t surge due to organic/inorganic growth. Company pays lesser dividends as number of shares have now declined in the market.

As per figure 1, I believe negative interest rates will cause further turmoil in equity markets for foreseeable future. Currency depreciation will boost exports which could start currency war in international markets. However, this measure will eventually raise inflation forcing central banks to raise interest rates, contributing towards stable economy.