Negative interest rates, explained — and how they could turn the world of banking upside down

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Imagine a world where you pay a bank to hold onto your cash and a bank pays you to take out a loan. This isn’t an alternate dimension — it’s what supposedly happens when interest rates turn negative.

Rates below zero are an unconventional economic concept that could turn the world of banking on its head. Though Federal Reserve Chairman Jerome Powell said Sunday that negative borrowing costs won’t likely be an appropriate policy for the U.S., consumers may be feeling uncomfortably close to that reality already.

The Fed slashed interest rates to zero in a surprise move Sunday, while Treasury yields across the curve have plunged to their lowest levels ever. Central banks in Europe and Japan have already forced interest rates into a somersault. Meanwhile, yields on shorter-term Treasury bills that mature in one year or less have already dipped below zero.

But it comes with fine print: Experts caution that this policy doesn’t exactly come to fruition in the way you’d expect. It also might cause more problems than it solves.

“It’s the central bank equivalent of throwing something against the wall to see if it sticks,” says Greg McBride, CFA, Bankrate chief financial analyst. “That’s why negative interest rates are not proven to be effective. They are still nothing more than an experiment.”

Here’s what you need to know about negative interest rates, including how they work and how they can impact you, whether you’re a borrower, saver or investor.

What are negative interest rates?

A negative interest rate is exactly how it sounds — it’s when an interest rate (or a yield) falls below 0 percent.

It seems counterintuitive. After all, how can a rate actually fall below zero, a number that’s literally meant to be a floor for traditional borrowing and lending activities? But it’s not as impossible as it sounds. Government debt in several advanced economies are already trading in negative territory.

Take Germany, for example. Its government bond yields are trading in the negative territory all the way out to 20 years. Bond yields are negative in France, Denmark and the Netherlands right now, and they were once sub-zero in Belgium.

Since the coronavirus has ravaged global debt markets, the volume of bonds in Europe trading with a negative yield has risen to $5.83 trillion from $4.5 trillion at the end of December, according to data from financial services data company Tradeweb.

But negative rates can happen more from just a bond yield perspective. A central bank can also cut its benchmark interest rates into negative territory — though it’s an experimental and unconventional policy.

The Riksbank of Sweden, the oldest central bank in the world, was among the first to implement what’s now known as a negative policy rate, when it announced in 2009 that it would charge banks to hold deposits. Technically, however, the central bank of Denmark in 2012 became the first to bring its key policy rate below zero.

Today, the European Central Bank’s (ECB) interest rate for deposits is minus 50 basis points, while the Bank of Japan’s (BOJ) short-term interest rate target is minus 10 basis points.

“Negative rates have been one of the unconventional policy tools [used] since the global financial crisis,” says David Lebovitz, executive director and global market strategist at J.P. Morgan Asset Management. “If you look at any traditional income textbook, there is no mention of negative interest rates. This has been an experiment over the course of the past decade, with the main players being people like the ECB and the central bank of Sweden.”

How negative rates work

Think about what normally happens when you borrow and save. It isn’t free to take out a loan — it comes with a cost, otherwise known as an interest rate. Meanwhile, banks typically offer you a yield when you park your cash in their savings accounts or certificates of deposit (CDs). That’s because you’re essentially lending them money.

But the opposite happens in a world with negative interest rates.

“It flips the banking model on its head,” McBride says.

If a yield on a savings account is negative, you’ll (theoretically) have to pay a bank to hold your cash. Think of it like a storage fee. And if you go out and buy a car, you’ll (supposedly) make a little bit of money.

“A negative rate means you are more concerned with the return of capital rather than the return on capital,” Lebovitz says. “It’s meant to incentivize people to borrow money and take more risk.”

But consumer products showing a negative yield wouldn’t just one day happen on its own. It’d likely be determined based on the interest rate that the Fed sets: the federal funds rate. If officials decided to cut that benchmark borrowing cost, they’d then elect to charge banks a fee for parking their reserves in accounts at the Fed. Banks would then pass that policy rate on to consumer products, meaning it’d get filtered through to the rest of the economy.

That’s only part of the picture. Bond yields can also offer a negative net return, with or without the Fed’s help.

“It’s possible that the 10-year Treasury yield could be negative even though the federal funds rate is zero,” says Bill English, finance professor at the Yale School of Management who spent more than 20 years at the Fed.

To explain why, it’s important to remember how bond yields generally work: When prices rise, the return that they generate falls. In other words, increased demand for bonds is what prompts yields to turn negative.

Technically speaking, a negative yielding bond is simply one that gives back less money than what was spent on the initial investment.

“A negative bond yield doesn’t mean that the lender has to pay the borrower a coupon rate,” McBride says. “It just means that the price has been bid so high that even with the coupon income over the life of the bond, you still are not going to make a profit when you get your principal back at maturity.”

What’s the purpose of negative rates?

Negative rates from central banks seem to be reserved for the most desperate of times.

Coming out of the Great Recession, central banks around the world were struggling to revive their economies. While the Fed slashed rates to zero and instituted a massive bond-buying program to push down longer-term rates, the ECB and BOJ set their sights on something more.

Fearing a deflationary trap, these central banks started betting that negative rates would spur intense levels of borrowing and spending. After all, why would a consumer prefer to keep their money in an account at a bank, when they could be borrowing money and making a profit? And why would a bank not lend out to businesses and consumers when they’d be penalized for holding onto cash at the Fed?

“The idea of bringing policy rates and interest rates broadly into negative territory is really to stimulate the flow of credit and to essentially encourage risk-taking on the part of consumers and investors,” Lebovitz says.

Even trickier, officials theorized that negative rates could devalue the country’s currency. It would push foreign investors out and cause an uptick in demand for the country’s exports. That’s been a major talking point for President Donald Trump — one of the main reasons why he pressured officials throughout 2019 to reduce rates to “zero or lower.”

“The Swiss went to minus 75 basis points in large part because they were worried about the foreign exchange value,” English says. “The Swiss franc was increasing too much relative to the world, and that was reducing Swiss exports and increasing Swiss imports, weakening the economy. By pushing rates sharply negative they’re able to damp the strength of the Swiss franc.”

What are the major consequences of negative rates?

On its face, it sounds like a good deal. Who doesn’t want to earn a solid return on the car loan they’re about to take out? But experts say the experimental policy doesn’t always lead to the outcomes theories would suggest.

The first reason starts with a caveat: Lenders want to be compensated for loaning out to a potentially risky borrower. That means if yields were to turn negative, it doesn’t mean you’d literally be paid to take out a mortgage or an auto loan, McBride says.

“They don’t want to do it from a business perspective,” McBride says. “Rates might be low, but it doesn’t eliminate the risk of lending.”

But being paid to take out a loan could potentially happen for low-risk borrowers. In Switzerland, reliable borrowers are often given a below-zero rate, English says.

Lenders also make money off of interest rates. Such a policy could squeeze their profits, ultimately deterring them from lending in general. That could slow down the economy needlessly.

That’s been the case in the current countries where negative rates have taken hold. No one is lending, which has suffocated demand and weighed on growth, thus making it a necessity to keep rates lower for longer.

“It’s just not profitable for banks to lend at those levels, and the demand hasn’t materialized,” Lebovitz says. “If the demand materialized and you saw credit flowing through the economy, you could move interest rates back out of negative territory. Now, they’re stuck with negative rates.”

There’s also a clear concern that negative yielding consumer products could cause bank runs in the masses. People might prefer to keep their money under their mattress, where the interest rate is at least 0 percent, instead of parking it in a savings account. That’s made banks all the more reluctant to pass on negative rates to consumers.

Another concern is that a too-low negative federal funds rate could simply discourage banks from keeping deposits at the Fed in general, English says. Instead, they could opt to convert their reserves to currency, which could strain the financial system. Experts often call this a “reversal rate.”

And just as it was difficult for the Fed to hike rates in 2018 during a time of solid economic growth, it’s hard to shake the negative interest rate cycle once it begins. The ECB, BOJ and Bank of Switzerland are still in the negative zone, despite the recession ending more than a decade ago. Experts say their economies aren’t in any better shape now than before those policies were implemented.

“These economies are still struggling with below-target inflation, the banking sector is damaged, and it’s difficult for them to remain profitable,” Lebovitz says. “We’ve seen them throw their hands in the air and say, ‘This isn’t really boosting inflation and reviving economic growth by increasing risk taking.’”

How negative rates would impact you

It doesn’t look like negative interest rates will be happening in the U.S. anytime soon. Powell’s Sunday message was a reiteration of what officials have said about the policy previously, which means that the sentiment still hasn’t changed even though rates have since fallen.

Still, if things got really bad, English says he could envision a scenario in which the Fed changes its tune. If that happens, individuals who are saving or living off fixed income would be left behind in a negative-rate world. Just as savers and retirees haven’t benefited from more than a decade of ultra-low rates, they’d be hit extra hard if a negative policy were to take hold.

“Think about what you’re getting paid on your checking account today, and imagine relying on that to fund your day-to-day activities,” Lebovitz says. “If you think zero rates are causing a problem for folks like that, negative rates are going to exacerbate it.”

Other former and current central bankers have also warned about the potential economic woes that such an unconventional policy could cause, mainly on the grounds that there isn’t enough research to suggest whether negative rates could help.

The Fed doesn’t “want to take a chance by undermining profitability in the banking sector or moving rates into negative territory without proof” that it could work, says Lebovitz. “They would really need to be out of bullets and grasping at straws.”

But bondholders of negative yields seem to believe there’s a way to game the system. Buying a sub-zero bond and holding it until maturity is a guaranteed way to lose money, but if you sell it as prices continue to rise, you’ll end up making more cash while also holding onto a safe-haven investment.

“People buying bonds at negative rates, they’re gambling that the rate is going to go lower,” McBride says. “If they hold it to maturity, they’re going to guarantee a loss.”

The bottom line is, consumers won’t benefit from this policy, McBride says. And even if banks slash yields to zero, you’re still better off keeping money in the bank than putting it under your mattress, he says.

“It’s federally insured, and you’re completely protected from loss,” McBride says. “You put that money under the mattress, you’re in no protection against loss or theft.”

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