T3 Navigator | Negative Interest Rates – Navigating Uncharted Waters
March 31, 2016
The last three major real estate downturns had their roots in the financial sector. Even though properties experienced extraordinary deflation during each of these downturns, over time the markets recovered with inflation stimulating a long-term upward trajectory in property values. For the first time in our lifetimes, however, negative interest rates could trigger a deflationary cycle resulting in the next real estate downturn.
The real estate industry is no stranger to plunges in property values. Nevertheless, a downturn coupled with deflation will be unlike anything we have experienced before. To illustrate how bizarre this can be, in Denmark, where they instituted negative rates to protect their currency, some borrowers with adjustable rate mortgages ended up with the banks paying them. In a deflationary cycle, the so-called mattress effect can become a reality; i.e., your money is worth more under your mattress than it is in a bank or an investment that is depreciating in value.
The key challenge facing the Central Banks and the Fed is how far to cut interest rates in order to stimulate growth and to increase inflation modestly without creating another housing bubble.
What Countries with Negative Interest Rates Hope to Achieve
Our whole financial system is built on positive interest rates. When interest rates go negative, banks charge their customers and other financial entities for leaving their money on deposit with them. The longer the money is held on deposit, the less the balance becomes. This is the exact opposite of an inflationary cycle where cash loses value as prices increase. The goal during an inflationary cycle is to buy before prices increase even further. In a deflationary cycle where values are declining, the goal is to delay purchasing as long as possible in order to obtain the lowest possible price.
Countries that have instituted negative interest rates hope to encourage more lending as opposed to leaving the money on deposit with a Central Bank. Negative interest rates also tend to drive down the value of the country’s currency. The result is their exports become cheaper while imports become more expensive; this helps their balance of trade. Moreover, there’s little incentive to save when bank balances decrease due to the negative rates. The hope is that people will spend more money, employment will increase, inflation will return, and that the next recession will be avoided.
Are Negative Interest Rates Possible in the U.S.?
“What I would like to make clear is that this is not actively a subject that we are considering or discussing. The committee continues to feel that we are on a course where the economy is improving and inflation is moving back up.”
Trillions of Dollars of Negative Rate Bonds Flood the International Markets
While some experts question whether the Federal Reserve can legally reduce rates below zero, other countries such as Denmark, Japan, Sweden, and Switzerland have already ventured into negative interest rate territory. According to Bloomberg News, $1.1 trillion worth of German bonds and $4.5 trillion in Japanese government debt carry negative interest, and more than $7 trillion bonds overall had negative yields.
How Do Negative Interest Rates Work?
According to Nordea, Scandinavia’s largest bank, negative interest rates only help central banks to defend their currency. For those trying to stimulate the economy, negative rates are the wrong tool. That’s good news for Denmark and Switzerland and bad news for the Euro Zone, Japan, and Sweden.
Denmark is a case in point and gives credence to the fact that negative interest rates can lead to a housing bubble. Negative rates have weakened the Danish currency, but they have failed to stimulate lending. Instead, short-term negative mortgage rates in Denmark have caused housing prices in Copenhagen to soar, possibly leading to their second real estate bubble since 2008.
Negative Interest Rates Have the Potential to Create a Currency War
Negative interest rates also carry the real risk of setting off a currency war. According to the New York Times, when a number of countries lower rates, it can set off a currency war. The downsides of a currency war include:
- Possible lower productivity if imports of capital equipment and machinery become too expensive for local business.
- If the currency depreciation is greater than desired, higher than desired rates of inflation and capital outflows may occur.
- Greater protectionism and trade barriers can impede global trade.
- Increased currency volatility, which could deter foreign investment.
Potential Impact of Negative Rates on the U.S. Real Estate Market
According to Scott Minerd, the global chief investment officer for Guggenheim Partners, bond markets are global. Negative rates abroad are among the factors depressing interest rates in the United States. Furthermore, declines in German rates are likely to lead to additional declines in American rates as well, even as the Fed intends to push rates higher. This is good news for mortgage rates, but it could also be the trigger for the next housing bubble in the U.S.
In addition to a potential housing bubble, Jim Rogers argues that these unconventional monetary strategies (negative interest rates) will lead to a stock market rally in the near future, with deep trouble later this year and into 2017. He fears that financial Armageddon is just around the corner. It’s been seven years since there has been a decent correction in the stock market. Markets are supposed to have economic slowdowns he warns; that’s the way the world has always worked.
The bottom line is that negative interest rates have led us into uncharted waters. With an increasing number of countries jumping on the negative interest bandwagon, the risks of a currency war are greater than ever. If the negative interest rate trend continues, the probability of a housing bubble with a subsequent deflationary period where everyone’s entire modus operandi will be turned upside down becomes increasingly more likely.
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