The larger fear that lurks beneath debate over negative interest rates

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The Bank of Canada signalled a willingness to consider a sub-zero interest rate policy in December if economic conditions warrant. Since that time, however, a growing chorus of economists have argued vehemently that negative rates are not only unhelpful but destructive.

The larger fear lurking beneath the negative-interest-rate debate is that negative interest rates – which were widely deemed impossible only three years ago – is a signal that central banks are grasping at straws and have reached the limits of their ability to support developed market economies. This declining credibility implies that asset markets, driven higher by central bank monetary policy explicitly designed to do so, will succumb to gravity and head sharply lower.

The Bank of Japan implemented a negative-interest-rate policy on Jan. 29 and this set off a wave of global equity market weakness focused on the financial sector. In Japan, market reaction was the exact opposite from what the BoJ wanted – falling equity prices and a sharp rally in the yen.

On Feb. 5, Credit Suisse's fixed-income team was succinct about the connection between negative rates, banks and what they termed "a growing fear of [central bank] policy impotence.

"Our rates strategists highlight that the proportion of [developed market] government bonds with a negative yield now amounts to almost a third, providing a clear signal of the policy's impact as a financial-system tax [by encouraging safe-haven investing in bonds and also reducing bank profits on loans], helping explain some of the pressure on financials…

"With policy-makers increasingly focusing on [the negative interest rate] tool," the Credit Suisse team continued, "we interpret part of the market's stress as a signal that there is little confidence in the ability to reverse a new downturn in growth."

Declining faith in central bank influence on equity markets could have extreme effects on global markets. Loose monetary policy was designed to push investors away from lower-yielding bonds and into equities, which in turn would result in corporate investment and employment growth.

It hasn't quite worked that way. Central banks have successfully boosted asset values but the global economy has remained sluggish and corporate investment muted. In a 2015 research report, Citi credit strategist Matt King wrote that it is "linkage between investment (or the lack of it) and all the stimulus which we find so disturbing. If the first $5-trillion of global QE, which saw corporate bond yields in both dollars and euros fall to all-time lows, didn't prompt a wave of investment, what do we think a sixth trillion is going to do?"

Mr. King's warnings about the effectiveness of monetary stimulus have been borne out by the more recent move to negative interest rates. The amount of developed-market sovereign debt has indeed climbed to more than $6-trillion (U.S.) in recent weeks. Despite this, the Organization for Economic Co-operation and Development was moved to cut global GDP growth estimates this week from 3.3 per cent to 3 per cent.

Negative central bank policy rates are unprecedented and their mid- and long-term effects are largely unknowable. Faced with uncertainty, global investors have reacted the same way they usually do – reducing portfolio risk by selling equities and buying bonds. There is also the fear that central banks are "doubling down" on a policy of monetary stimulus (and debt creation) that hasn't been working to motivate economic growth. Because negative rates have never been attempted before, the potential for unforeseen consequences in the global financial system are also on investors' minds.

As investors, all we know so far is that we're in uncharted monetary policy waters and that, to date, the drastic step of negative-policy rates has not worked on either currency or equity markets, or as a catalyst for economic growth. In light of the market volatility after the Bank of Japan announcement, Canadians can hope that the Bank of Canada can avoid the negative-rate experiment with the help of stronger economic growth.

Investors should expect market volatility to continue. Central banks, after bailing out the global financial system, have acted as a financial and psychological backstop for investors, boosting confidence and equity buying. As confidence in central bank effectiveness fades, market returns could fade right alongside them.