Could interest rates turn negative?
Our views on negative interest rates – how they work, what they mean, and whether they’ll actually happen.
2 min read
With speculation that central banks could take more radical action in the COVID-19 fightback, we look at the hype and the likelihood.
Can you imagine being paid to borrow money? That, in essence, is what could happen if the Bank of England (BoE) decided to break the zero barrier on the base rate and go negative.
While the UK’s base rate is currently 0.1%, the BoE has said it’s considering going into negative territory for the first time in its 324-year history. That means commercial banks would be charged for depositing money with the central bank.
How would negative interest rates work?
Interest rates are vital because they influence how businesses and individuals behave. If they’re low, we can borrow money cheaply, which allows us to spend more, boosting economic growth and pushing up inflation. If they’re high, we tend to spend less and keep more of our money in savings to take advantage of better rates.
The BoE’s Monetary Policy Committee sets the UK base rate, which is the interest it pays commercial banks. It’s a tool to influence the level of interest these banks charge businesses and households to borrow money or pay on their savings. It also helps the central bank achieve its aim of controlling inflation at around 2%, which is the target set by the government.
In theory, negative interest rates should stimulate economic growth by encouraging banks to lend money, and making it easier for businesses and households to borrow and spend.
Below-zero interest rates are unconventional, but they’re not new. Sweden’s central bank was the first to introduce them in 2009, with the eurozone following in 2014 and Japan in 2016. Other areas that currently have negative interest rates include Switzerland and some Nordic countries.
What do negative interest rates mean for investors?
Shortly before BoE governor Andrew Bailey said negative interest rates were “under active review” in May, the UK sold a three-year government bond with a negative yield for the first time.
This means that investors have effectively paid to lend the government money, knowing they will get less than they paid when the bond matures.
In a negative interest rate environment, investors are likely to avoid expensive government bonds, while riskier assets like equities, or other types of fixed income, look more attractive as they tend to offer more opportunities for greater potential returns.
And for homeowners and savers?
While negative rates wouldn’t change fixed-rate mortgages, banks could offer lower rates to people on tracker mortgages, although negative (tracker mortgage) rates are unlikely as many of them come with a minimum rate applied. Variable rates are also likely to stay positive.
However, a negative rate mortgage is not entirely out of the question – Denmark’s Jyske Bank was offering homeowners loans at a rate of -0.5% a year in August 2019 – but the associated fees mean people are still likely to pay more than they borrowed.
In theory, savers could suffer from negative interest rates as banks could charge them to look after their cash. The evidence from the eurozone and Japan suggests this is unlikely, though, as banks want to avoid customers withdrawing all their money and keeping it at home.
How likely are negative interest rates?
The effectiveness of negative interest rates is disputed. When the eurozone and Japan followed this policy, bond yields fell and households and businesses began to borrow money again. However, their currencies weakened and the profitability of banks deteriorated as their margins were squeezed.
With this in mind, Lilian Chovin, Investment Strategist at Coutts, says it is by no means certain that we would see any such move in the UK.
“We believe that negative interest rates would offer little benefit in the UK and that the Bank of England is unlikely to introduce them in the near term,” he says.
“Instead, we think the central bank could try other measures first. These could include cutting interest rates to 0% and expanding its quantitative easing programme.”
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