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It's Alive! Negative Interest Rates Turn Rogue

By Alex Dumortier, CFA – Mar 8, 2016 at 1:35PM

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As the U.S. economy diverges from those of Japan and the eurozone, negative interest rates reveal a dark side.

Following five straight days of gains, U.S. stocks are lower in early afternoon trading on Monday. The S&P 500 (SNPINDEX: ^GSPC) and the Dow Jones Industrial Average (DJINDICES: ^DJI) (DJINDICES: $INDU) are down 0.50% and 0.15%, respectively, at 1:32 p.m. ET.

Look out below! Taking interest rates below the zero boundary isn't a riskless experiment. Lookdown window at the Tokyo Tower in Tokyo, Japan. Image source: Sebastian Kamper, republished under CC BY 2.0 DE.

There are now five central banks, including the European Central Bank and the Bank of Japan, navigating the uncharted waters of negative policy interest rates.

On Sunday, two economists at the Bank for International Settlements, the Basel-based central bank to central banks, published a note in the bank's quarterly review on the nuts and bolts of implementing negative interest rates.

The duo concludes that "the experience so far suggests that modestly negative policy rates transmit through to money markets and other interest rates for the most part in the same way that positive rates do."

However, they point out that negative rates are hurting banks' profits and jeopardizing the business model of financials that are tasked with earning a return of behalf of savers, including mutual funds and insurance companies.

Finally, they also warn that "there is great uncertainty about the behavior of individuals and institutions if rates were to decline further into negative territory or remain negative for a prolonged period." Here be dragons!

Weird science
The warnings come just as Japan, the latest economy to join the negative-rate club, appears to be experiencing unexpected -- and unwanted -- effects of their monetary experimentation.

Financial Times is reporting today that, for the first time in three years, unions at the country's top three banks, Mitsubishi UFJ Financial Group, Sumitomo Mitsuo Financial Group, and Mizuho Financial Group, will not demand wage increases.

To the BIS economists' point, the FT article contains the following quote from a "senior trade union official":

Negative rates are backfiring, in this sense. Our real worry is that all their small business customers in the regions will use the example of megabanks as an excuse to avoid wage hikes themselves.

So much for trying to spur inflation...

Another union official from one the three megabanks specifically linked abandoning demands for higher wages to reduced profits stemming from ultra-low rates.

Finally, unions at leading insurers will not be seeking higher wages, either.

The European Central is expected to take its policy rate further into negative territory from its current level of -0.30% on Thursday.

The U.S. and other major developed economies are on different paths
In the U.S., Federal Reserve Chair Janet Yellen told Congress in February that the Fed was evaluating negative interest rates as a policy option, but this is a precautionary rather than preparatory exercise.

Prices in the Fed Funds futures currently suggest investors are assigning a zero probability to the scenario in which the Fed's main policy rate ends the year lower than it is now.

That confidence and the improved economic fundamentals it reflects illustrates the divergence that has opened up between the path of the U.S. and that of other major economies -- particularly those of the eurozone and Japan.

It's part of the reason that this Fool prefers high-quality universal banks Bank of America and JPMorgan Chase over their European counterparts, even though the latter sport valuations that, on paper, look very alluring (mind you, at 9.1 times expected earnings per share for 2016, shares of B of A are eye-catching, too). 

Alex Dumortier, CFA has no position in any stocks mentioned. The Motley Fool recommends Bank of America. 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.

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