How low will they go?

The dangerous interest-experiment by the European Central Bank

This week, the area of negative interest rates in Europe was remarkably widened. While investors were just getting used to negative yields for government-bonds, on Tuesday german bank ‘Berlin Hyp’ set a new landmark.

The relatively small bank became the first ever non-state borrower who issued an EUR-denominated debt (of 500 million over 3 years) with a negative yield of 0,16 % at the initial sale.

In other words, any buyer of these (very safe) covered bonds invests in something he already knows now that the return will be negative at maturity in 2019.

This ‘milestone’ in europes financial history was reached just ahead of the European Central Bank’s (ECB) policy meeting on Thursday in Frankfurt, led by former Goldman-Sachs banker Mario Draghi, when negative interest rates will be the focus.

A little background: for an economy with overcapacity or a low rate of inflation, the traditional monetary policy is to lower the interest rate to boost credit-demand and investments as well as to reach defined inflation-targets (which is 2% in the eurozone).

This traditional policy-options have proved ineffective in Europe resp the eurozone, despite the ECB brought its deposit rate all the way to 0% in July 2012. When that didn’t work, the ECB started to ‘experiment’ and went negative to -0.1% in June of 2014 and by December 2015, the ECB had brought the deposit rate down to -0,3%. On Thursday, the market is expecting the ECB to cut the rate further below to -0.4%

Rates below zero have never been used before in an economy as large as the eurozone. The main effect of negative rates: They punish banks that hoard cash instead of extending loans to businesses or to weaker lenders.

Another intended effect by the ECB-policy is an economic stimulus triggered through the exchange rate. When safe interest rates are negative in Europe and positive in the United States for instance, investors around the world (should) shift their holdings from EUR to USD thereby lowering the EUR/USD exchange rate that in turn (should) boost European exports, which again could be a way to strengthen economic activity in the eurozone.

Here is the catch and that’s why many observers of financial markets are convinced, that negative rates may not be such a great idea (and I personally agree with that view).

The lower the ECB-rates go, the harder it is for European banks to convince investors that their business models are secure and are a good long-term bet to make money. In plus, the ECB has failed to convince the sceptics of their policy, why something that’s bad for banks should be good for credit-driven economies as the eurozone.

And if low rates and a weaker currency would really boost the economy, then Japan (where exactly this policy-mix has failed for 25 years to bring the intended results) would be the number 1 economic superpower worldwide.

That brings us back to the small german bank ‘Berlin Hyp’. The first covered bond by a non-state borrower with a negative yield was nonetheless a success and found plenty of buyers. The rationale behind is, that investors expect even further falling rates on the market – and in this case, they could sell the (covered) bond on the secondary market with a profit – despite negative rates.

Financial history: On March 8, 2016, Berlin Hyp issued the first ever covered bond with a negative interest at the initial sale.