How Do Negative Interest Rates Affect Investors?
If you read the news, you will have most likely come across articles in the last few months about the possibility of negative interest rates in the UK. Last month, the Bank of England (BoE) reportedly asked UK banks whether they were operationally ready for negative rates, should they be introduced.
But what are negative interest rates? How could they be implemented? And what effect could they have on investors and traders? In this article, we will answer these questions, we will also look at what type of stocks could benefit from negative rates and much more!
Interest rates play a big role in our daily life: the interest rate we get from a deposit account at the bank, the rate we pay on our mortgage, or on our overdue credit cards. The same is true, only even more so, in the commercial and the investment worlds: the rate of interest UK government bonds pay, the interest a company pays when taking out a loan from the bank, the rate of interest one bank charges another bank when lending it money (this last one is known as LIBOR, or London Inter-Bank Rate) and so forth.
All of these rates of interest will be different (i.e. they will all be set at different levels) but they are all driven by the "base rate".
What Is the Base Rate?
The base rate is the interest which a central bank, like the BoE, pays institutions like banks for money stored at the central bank and the rate that it charges them when they need to borrow. The base rate affects all other interest rates and it is the biggest tool in a central bank's toolbox when it comes to managing the economy.
In times of slow economic growth, interest rates are usually moved lower in an attempt to stimulate the economy. When interest rates are lower, banks will be more inclined to lend money to their customers than deposit it at the central bank.
Moreover, as banks tend to pass on the lower rates to their customers, people are more likely to borrow money and less inclined to save due to the lower interest rates. These factors have the effect of encouraging people to spend or invest more money than they would usually and this, in turn, creates stimulus for the economy.
Conversely, when central banks think an economy is overheated and there is a risk of inflation, they will increase base rates in an attempt to slow the economy down.
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Why Would the BoE Introduce a Negative Base Rate?
If the BoE were to impose negative interest rates, this would mean that, instead of earning interest, banks would be required to pay the BoE interest on any money stored there. But why would the BoE do this?
Global interest rates have remained low since the "Great Recession" in 2008, when there was an urgent need for central banks to take action to stimulate the economy. Now, with the coronavirus pandemic threatening to have a huge negative impact on the economy, base rates (currently at 0.1% in the UK) do not have far to go before they get to zero.
Central banks have to ask themselves what they can do to stimulate the economy and negative interest rates is one of the possible answers.
Negative interest rates would penalise banks for storing money at the BoE, which would increase the incentive for banks to lend more money to its customers, hopefully increasing consumption, investing, and, consequently, boosting economic growth.
Negative interest rates seem like a strange concept but if the BoE were to introduce them, they would be following in the footsteps of the European Central Bank, Japan, Switzerland, Denmark and Sweden (who ended their experiment with negative interest rates in December 2019).
How Could This Affect Banking Customers?
In the BoE's 326 year history, they have never introduced negative rates. Therefore, other than the likelihood of loans being more easily accessible, it is difficult to predict how negative interest rates would affect banking customers. One can only speculate.
British banks are not obligated to pass on the BoE's base rate to their customers, although it definitely has an impact on their decision-making. Therefore, we cannot say with any certainty whether, if the BoE did introduce negative interest rates, this would be passed on to our bank accounts.
The idea of banks passing negative rates to their customers is unusual and could be dangerous for the banking industry. Charging customers interest to store their money could lead to a run on the banks, with people preferring to hold their cash for free rather than pay to store it. Moreover, the thought of a customer taking out a loan and paying back less than what they borrowed seems almost crazy.
However, as far fetched as it may seem, there are precedents for both of these situations. For example, in Switzerland, many banks have begun to charge their most affluent customers to store money with them, leading to these high worth individuals seeking alternatives, such as private storage for their cash.
In 2019, a Danish bank launched the world's first ever negative interest rate mortgage. Jyske Bank began offering borrowers a 10 year deal at -0.5%. This means that every month, the amount outstanding on the mortgage reduces more than the amount repaid by the borrower.
What Could Negative Rates Mean for Investors?
If the BoE introduces a negative base rate, expect easier access to loans for financing an investment. Interest rates on savings will likely drop even lower than they currently are, meaning that investing your money, or trading with it, will become more appealing than leaving it in the bank to earn interest.
There is a justified concern that negative interest rates could lead to people being reckless with their money. Therefore, despite this potential increase in your appetite to invest, do not forego usual risk management practices. Extensively research the fundamentals of a company before investing your capital, regardless of whether it is borrowed or not.
If you are motivated to trade more on the financial markets, such as the Forex market, do not do this without firstly educating yourself thoroughly on trading. Trading the financial markets is not easy and, as with anything in life, you need to practice in order to be successful.
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Investment Opportunities for Negative Interest Rates
Negative interest rates will impact consumers' behaviour, which will in turn affect the financial markets in different ways. Below, we will look into the possible effect on some of the different industries in the UK.
A negative base rate might not necessarily mean negative interest mortgages, however, it is likely to result in cheaper and more accessible mortgages for homebuyers. This is likely to benefit the property market. But other than buying property, how can you profit from this potential upturn in property sales?
One way to attempt to profit from a strong property market is through UK property ETFs (Exchange-Traded Funds), such as the iShares UK Property ETF. ETFs are a type of investment product which are listed on stock exchanges and consist of a basket of securities (such as stocks). They usually track an underlying sector, such as property.
Alternatively, investors may seek stocks in listed companies involved in real estate, such as estate agents like Rightmove.
Depicted: Admiral Markets MetaTrader 5 - Rightmove PLC (#RMV) Daily Chart. Date Range: 1 April 2020 - 3 November 2020. Date Captured: 3 November 2020. Past performance is not necessarily an indication of future performance.
Interest rates are one of the primary drivers of a nation's currency value. The simple relationship between the two is that when interest rates rise, currency value tends to rise also. Conversely, a fall in interest rates tends to cause a fall in currency value.
Therefore, if the UK introduces negative interest rates, the GBP is likely to fall in value. One currency pair where this might be especially prevalent is the GBP/USD. This is due to the US dollar being viewed by many as a safe haven asset, meaning that if the GBP falls, British investors may invest their money in US dollars.
Depicted: Admiral Markets MetaTrader 5 - GBPUSD Daily Chart. Date Range: 10 April 2020 - 3 November 2020. Date Captured: 3 November 2020. Past performance is not necessarily an indication of future performance.
A knock on effect of a depreciation in GBP will be an increase in demand for British exports, which will seem relatively cheaper to foreign countries. Therefore, a negative interest rate could bring an increase in the fortunes of British exporters such as BP (British Petroleum), British American Tobacco and Diageo (alcoholic beverages).
Depicted: Admiral Markets MetaTrader 5 - Diageo PLC (#DGE) Daily Chart. Date Range: 3 April 2020 - 3 November 2020. Date Captured: 3 November 2020. Past performance is not necessarily an indicator of future performance.
Another safe haven asset, investors tend to flock to gold in times of economic upheaval and uncertainty. If customers are charged to save their money in banks and the GBP weakens, many people are likely to turn to gold.
Some government bonds (gilts), which are considered to be a safe investment are already selling at below 0% interest. The introduction of a negative interest rate will see these bonds' yield fall further, and possibly encourage investors to move away from bonds and look at other safe investments. This is also likely to increase investment in gold.
If the UK introduces negative interest rates, the value of gold is likely to increase.
Depicted: Admiral Markets MetaTrader 5 - Gold Daily Chart. Date Range: 12 September 2019 - 3 November 2020. Date Captured: 3 November 2020. Past performance is not necessarily an indication of future performance.
The prospect of negative interest rates is certainly a controversial one. They could lead to loans being approved too easily, much like before 2008, and be used to make reckless investments. There is a real danger to the banking industry of people removing their savings if they are charged to store them at their bank.
There is also a belief that negative rates could have the opposite effect on consumer behaviour, causing people to fear for the future of the economy and hoard more money instead of spending it. From the countries which have already implemented negative rates in the past, there is little evidence to support that they have successfully generated growth.
However, BoE policy makers will argue that as the economy continues to deteriorate due to the coronavirus pandemic, they need every possible tool at their disposal to try and rectify it.
We are still in the dark as to whether negative rates will be implemented, however, it is looking more likely. As we have highlighted in this article, the introduction of negative interest rates in the UK could present several trading and investment opportunities for you.
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.