We got a surprise ending to January when the Bank of Japan decided to lower its benchmark interest rate to -0.1% and join Denmark, Switzerland, and the European Central Bank in the negative rate club.
It will now cost banks money to hold new reserves at the Bank of Japan. But it's the act of rates moving into negative territory and what might happen in response that matters most to investors, not the mechanics of monetary policy.
The rate decision caused a positive furor in markets around the world; the U.S. and Japan saw particularly strong rallies on the news. It also lit a fire under currency markets -- almost every currency strengthened against the Japanese yen. For Japan, this might be what matters most in the near term, but that depends on what other countries do next.
Not the first big move
Japan had everybody's attention at the end of last week, but this is hardly the first unconventional monetary act of the last few years. We've had quantitative easing in the U.S. and Japan, and a large swatch of Europe already has negative rates. The U.S. Federal Reserve has said it could go negative if it needs to as well.
The end result? Not only are overnight rates negative in many countries, but many short-term bonds also carry negatives rates. According to a recent Financial Times article, one-quarter of JP Morgan's index for government bonds now trades at a negative yield.
You want me to pay you?
Negative interest rates had been an unusual thing -- and until recently were considered highly unlikely. (After all, instead of getting paid for your deposit, you're actually paying a financial institution to take your money.)
So far the "you" in this case are banks, not individuals (unless individuals are invested in the short-term debt selling at negative rates). Banks in Europe haven't been passing the cost along to their customers, and instead have been absorbing the cost. I'm guessing banks in Japan will do the same.
The idea here is that banks and consumers will do something else with their money, because obviously, paying someone to hold it doesn't make much sense. Preferably, they'll invest it or spend it -- parking it at the bank will come with a penalty.
Who benefits if it works
If it works out as the Bank of Japan and European central banks hope, negative rates will spark growth in their economies from additional investment and spending.
Lower rates also mean a weaker currency, which is what has happened with the Japanese yen. If it lasts, this is a benefit to Honda Motor, Toyota Motor, and Japan's other exporters. More active and profitable businesses help employment, which should, in turn, help spending and the broader Japanese economy.
In the U.S., investors seem to be hoping that the Federal Reserve will step back from raising rates after Japan's extraordinary move has caused the yen to weaken. U.S. exporters have been struggling with the strong dollar, and another rate increase would likely lead to more dollar strength because investors will be drawn to U.S. bonds and other instruments paying higher interest rates.
If the Fed backs off, global investors will have less interest in U.S. bonds and the dollar. As long as inflation isn't a threat, this would help in the short term, so you can see why some investors might have become a little excited. The problem is it probably doesn't mean much in the long-term -- and there is no guarantee it will play out that way.
Who could lose out
But if this is why the markets rallied, it might not all be good news. A weaker yen is a negative for Apple and other companies that have significant sales in Japan, but that primarily do business in dollars. Similarly, it's bad news for manufacturers that are trying to compete with Japanese companies (unless they have strong competitive advantages and don't need to compete on price).
Which brings us to China and other emerging markets. Many Chinese exporters compete primarily on price, and one of the currencies the yen weakened against last week was China's renminbi (RMB). But that's only part of the story. In the past six months, the yen had been strengthening against the RMB. The negative rate decision undoes some of that move, but not all of it.
It's not just China. Emerging markets in general have seen their currencies weaken, which has helped exporters. Now that the yen has weakened, it's entirely possible China and other markets respond with lower rates or other actions to weaken their currencies. A race to the bottom and currency volatility in general would likely lead to more market volatility -- a scenario no one wants to see play out.
There is another potential loser from these negative interest rates, if the plans don't unfold as the Bank of Japan and other central banks expect: banks. With banks absorbing the cost of negative rates it's possible that banks will be even less likely to lend, because the added cost hurts their profitability.
This probably isn't the last moveThe Motley Fool isn't in the business of making macroeconomic predictions, but with so many extraordinary actions taken over the past few years, it seems unlikely to me that Japan will be the last to attempt to stimulate its economy with unconventional policies.
If the Chinese economy continues to struggle and capital continues to leave China, it seems quite possible we'll see China devalue its currency as it did last August. If this happens, investors should be prepared for some additional volatility in the market.
That doesn't necessarily mean a recession or a crisis. It might just mean more volatility as the market adjusts. And if the policies end up working, it might not even mean that.
No matter what happens, I believe it's an investing environment that favors investors who are aware of these factors but pay attention to competitive advantages, valuation, and the overall durability of companies when it comes to choosing specific stocks.
If you're investing with a time horizon measured in decades, a lot of this will probably just end up being nothing more than noise.
Motley Fool owns shares of and recommends Apple, which Nathan Parmelee also owns shares of. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.