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What impact could negative interest rates really have?

The Theory

In general, economic theory suggests that a lowering of interest rates should help stimulate a stagnating economy. The idea is that, in order to avoid lower returns on cash reserves held with central banks, commercial banks will make money more readily accessible to customers. This, in turn, should encourage small businesses to take out loans to fund expansion or prospective homeowners to take out a mortgage, thus helping to pump money into the economy. Lowering interest rates also has the potential to weaken a nation’s currency making exports more competitive and boosting inflation as imports become more expensive. Finally, as the policy results in lower government bond yields, the relative appeal of equities to investors should increase, consequently helping to boost that market.

Policy interest rates in the UK are still positive, but recent price increases in short-dated government bonds have meant that a few of them are trading at negative gross redemption yields. Effectively, their current price is more than the total coupons and capital that the investor will get back.

The Bank of England could set policy interest rates to be negative like the European Central Bank (ECB) has done but this could have unintended consequences. Negative interest rates could lead to unusual economic and market behaviour together with socially unproductive innovations. Cash hoarding, where physical money is effectively withdrawn from the banking systems and stored, being a good example of the real investment implications of negative interest rates.

Retail Savers

For commercial banks, negative interest rates mean that they will be charged for the privilege of holding reserves with the central banks and some may be tempted to pass on such costs to their customers. Indeed, we have already seen NatWest contact their small business customers to outline a change in their terms and conditions which effectively could result in the bank charging interest on credit balances. This may well be the thin end of the wedge with banks potentially looking, in the future, to charge personal customers who hold over a certain level of money with them. Although this remains a real possibility, in reality retail banks may find it hard to pass on the negative rates to the majority of their depositors.

If retail banks were to end the era of free banking for their customers, savers could simply just close down their deposit accounts altogether, choosing instead to either put their cash under the mattress (though vulnerable to fire and theft risk), or buy a safety box (though bearing storage cost and inconvenience compared to a bank account). From an economic point of view, the consumer’s decision not to deposit money with a bank makes more and more sense the more negative the deposit rate becomes. What would be the point in saving into a deposit account with zero or negative interest rates?

Banks could, therefore, decide to absorb the cost of negative interest rates themselves. However, this could lead to a squeeze on their profits as the gap between their lending and deposit rates becomes ever smaller. If profits begin to suffer too much, banks may even scale back their level of lending. Not the outcome the negative interest rate policy was meant to achieve!


Cash hoarding may however not always remain an option open to savers. A time may come when paper money is replaced entirely by electronic money. In fact, in May this year, the ECB announced that it would be phasing out the 500 Euro note and would stop issuing such banknotes from around the end of 2018.

Although this decision was deemed to have been taken on the grounds that it would help combat financial crime, many believe the threat of cash hoarding played a crucial factor. After all, abolishing the largest banknotes makes hoarding cash on a significant scale considerably more difficult.

Institutional investors

Ordinary customers may not be the only ones looking to make use of the figurative mattress to stash their cash. Many institutional investors are now beginning to debate whether it is worth holding physical cash in a vault instead of on deposit as rates fall further below zero and negative yields begin to reduce investment returns.

The German reinsurer, Munich Re, recently announced that it is looking at different ways in which to store cash in an attempt to avoid paying charges to central banks to hold its reserves. One proposal the company is experimenting with includes storing at least 10 million euros in two different currencies.

If Munich Re’s strategy is followed by others, it will, undoubtedly, begin to undermine the ECB’s negative interest rate policy with its aim to encourage bank lending and boost consumer spending.

In summary

With the economic future hard to predict and widespread uncertainty following the Brexit vote, it is more important than ever for us, in the financial services sector, to ensure that our financial planning tools accurately reflect the current situation.

Modelling interest rates has always been of fundamental importance when modelling investment risk and return over the long term and is even more so now. EValue has already taken steps to ensure that our asset allocations and optimum portfolios reflect the current changed economic conditions. However, we will continue to closely monitor market movement, study the influence and implication of negative interest rates and upgrade our asset model if and when it is necessary.

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