Skip to content

Negative Interest Rates: Unusual and a Difficult Phenomenon to Explain

With respect to interest rates, we live in a very interesting and indeed historical time. In some European countries, nominal interest rates are negative (while they are close to zero in the United States). A short while back this was thought to be impossible. Until it actually happened, it would have been difficult to imagine that interest rates would fall below the so called Zero Lower Bound (ZLB). Such an event was unknown. Indeed, even during the Great Depression, between two world wars, interest rates did not turn negative.

The Lender Pays the Borrower

With negative interest rates, implausible as it sounds, the amount one pays back on a loan is less than the amount that is initially borrowed. Thus the lender pays the borrower! Today, not only do commercial banks have to pay interest to the central banks of several countries for holding their deposits, but even interest rates on some government and corporate bonds are negative. The central banks that pay negative interest rates at this time are the Swiss National Bank (-0.75%), the Danish National Bank (-0.75%), the European Central Bank (-0.2%) and the Swedish Riksbank (-0.1%),  According to JP Morgan, one in four Eurozone government bond’s yields turned negative (equivalent to $3.6 trillion). At the corporate level, Citigroup has listed 53 bonds issued by European companies with negative interest rates, Nestle being one of them. Some Danish mortgages also have negative interest rates, although borrowers still have to pay various administrative charges that offset the negative interest rates.

Investors and Negative Interest Rates

Of course, even bonds with negative interest rates do pay coupon payments that are positive; no actual cash payment is collected from bond holders. So how do investors receive negative interest rates? The answer is that when the present value of the coupon payments and par value paid at maturity is calculated using a negative discount rate, the price paid for the bond is very high. The discount rate that equates the price of the bond to the present value of the future cash flows, including coupon payments and par value, is the net interest rate on the bond; in this case it has to be negative given the high price of the bond.

The question immediately arises: Why would an investor purchase such bonds? Clearly the investor does not intend to hold them until maturity but hopes instead to sell them before they mature at a price higher than the purchase price. In other words, she does not expect that economic conditions in Europe will improve any time soon, and she, therefore, thinks that interest rates will remain low—and consequently bond prices high–for quite a while longer. This view is not unreasonable. It is consistent with the fact that, at the time of this writing in February, 2015, the ECB has not yet started to purchase bonds under its Quantitative Easing program, which will presumably keep bond prices from falling and possibly even push them higher. Once started in March 2015, the ECB will purchase €60 billion worth of government and private sector bonds per month until at least September 2016. Under such a program, European interest rates are likely to remain low for a considerable amount of time, and could fall even further below zero, which is exactly what investors are betting on.

Harmful Effects

However negative interest rates are not harmless as they motivate financial institutions such as pension funds and insurance companies to invest in riskier and riskier assets in search of higher yields. Clearly, these are institutions that should be investing in safe securities, earning low but positive rates of return, to ensure that they have sufficiently liquid funds available to pay pension benefits to retirees and insurance claims to insured parties when the time comes. Low interest rates are so common that even the sovereign and corporate bonds of African countries, which typically pay high interest rates to compensate for their riskiness, now pay historically low yields because investors seeking slightly higher yields have moved their money from safer countries to these emerging markets and in the process have pushed African yields down. Clearly in a world of excess savings (and negative interest rates), the money has to flow somewhere, including to investments less safe than the bonds of stable, industrial countries. In addition to the high prices and low yields of emerging markets’ bonds, the search for higher returns reflects itself in European stock prices which are currently at a seven-year high, while the Japanese stock market is at an eight-year high. This is a remarkable phenomenon in light of the deflationary forces affecting those countries.

Unsettling Times

As I try to understand the fundamental forces that drive the global economy, I am reminded of Piketty’s book, Capital in the 21st Century (see one of my earlier blogs). What do negative interest rates have to do with Inequality? As one tries to reconcile the fact that there is no wage inflation with the occurrence of very high corporate profits, one would think that the rate of returns on capital should be high. If so, then interest rates should also be high, which is obviously not the case. One possible explanation is that these high profits are pure economic rents (returns above what would occur if markets were perfectly competitive). These are not only historical but also unsettling times!


Pierre Canac, Ph.D.
Associate Professor of Economics

See more posts by this author



share this post





Never miss an update...

Subscribe to the CSB Blog!