Something has happened in the world of interest rates that is seemingly impossible: they’ve gone negative.
Most notably, Japan and some European central banks are crediting (if that’s even the right word) negative rates on deposits.
This seeming impossibility resembles an alternative universe in which objects fall up and you lose weight by eating more. Imagine saying, "I'm going to borrow $100 from you, but don’t worry, I’ll pay you back next week, and I’ll only pay you $90."
What causes this phenomenon, and what does it mean to the investor?
There are some pretty complicated explanations but two are reasonably easy to follow. One is from the perspective of the central banks offering the negative rates, and the other from the investors that make the deposits.
When I was six years old, if I was still watching cartoons past the ungodly hour of 9 on a Saturday morning (on one of the three stations we got in those days), my mom would give me a choice: I could stay inside enjoying a day with her cleaning out a dusty cupboard, or I could go outside and play.
Central banks are doing the same thing. They want the banks that lend to them to invest in the economy to stimulate growth. How do they do that? They offer an unpalatable alternative, a negative rate. It’s not clear that this choice will work as well as my mom’s did, but that’s at least the intent.
On the other side of the equation, what might cause an investor to put money into something that loses value? Once again, it’s about comparison. If I lose less value investing at a negative rate than I would with whatever other choices I could make, I’ll take the negative rate.
If prices are headed down by say 10 percent, I’m better off not spending the money now because I’ll be able to buy more later, even if my bank account went down by 1 percent. That’s an example under deflation, but it’s the same comparative choice that investors make in all kinds of environments.
A friend of mine from Brazil told me that when inflation was skyrocketing there, people would either spend their money as fast as they could before it lost value, or buy hard goods like bricks that didn’t lose value. Simply put, they made the most economical choice.
What’s it all mean for the investor, or for the investment professional?
In the short term, financial markets can be kind of crazy. Bad news can make prices go up and good news can make them go down, except when they don’t. So maybe a new territory that’s hard to explain, like negative rates, isn’t the place to be making a big bet one way or the other.