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In economies from Japan to Scandinavia to central Europe, negative interest rates have exacted a heavy toll on financial institutions, says Tracy Chen, head of structured credit at Brandywine Global Investment Management.

The Philadelphia-based portfolio manager said when the governments of Japan, Greece, Sweden and Switzerland pushed interest rates into negative territory, they inadvertently damaged domestic bank stocks and chased fixed-income investors into other markets.

“If you look at the long-term bank stock trends from 1995 to now, the Japanese and European bank stocks, they are hammered,” she said. “They’re not going anywhere.”

While she acknowledged that the Japanese stock market is doing well generally, the TOPIX Bank Index largely remained below 2015 levels since negative interest rates were introduced in 2016. Furthermore, the STOXX Bank Index has not regained its 2010 levels since that time.

By comparison, the Dow Jones U.S. Banks Index has generally shown strong growth from 2009.

The problem with negative interest rates, she explained, is they damage the main profit mechanism for banks.

“Banks rely on net interest margin. If they don’t have that margin, I think they will only end up [in] the government’s ICU (intensive care unit).”

Chen said the key function that banks play in an economy is to transmit the monetary policy from the Central Bank to households and corporations.

“They are intermediaries,” she explained. “If the intermediary is not doing well, I think the monetary transmission system is stuck.”

Zombie countries

Furthermore, she said, negative interest rates create an environment where failing companies can temporarily hide their weaknesses.

“There are a lot of zombie companies in Europe and Japan,” she said. “The negative interest rate just shores up their balance sheets. They can still survive even with a negative profitability. And that’s not healthy for an economy.”

Nevertheless, Chen believes the U.S. is in a period of de-facto negative interest rates, with bond returns dipping below the rate of inflation.

“The Fed already said we are not going to have negative interest rates. We’re not going to be like Europe. And my argument would be, yes, they are saying that, but the real interest rate is already negative,” she said. “If you look at the U.S. two-year, five-year, and 10-year government bonds, they already have negative real yields.”

The situation makes foreign bonds more attractive to fixed-income investors.

“Even though the nominal rate is still positive, the real one is already negative,” she said. “And that is exactly why we have to invest globally. If you stay in the [U.S. market], bonds are trading at negative yields. It doesn’t make sense for us to invest in those bonds.”

So, for those who are curious about how negative interest rates would play out in the North American economy, she offered a word of caution.

“I would say be careful what you wish for,” she said.


This article is part of the Soundbites program, sponsored by Canada Life. The article was written without sponsor input.

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