Negative interest rates – what are they and why do they matter for investors?

Negative interest rates have been a feature of global markets since the 2008 financial crisis. Until now, the Bank of England (BoE) has kept UK interest rates in positive territory – if only by the smallest of margins.

Since the start of the year there’s been speculation the bank might be considering negative rates again. Despite the governor of the BoE previously saying negative rates aren’t on the cards any time soon, it’s still caused the market to wobble at times. But what are negative rates and what do they mean for investors?

What are negative interest rates?

When we say the BoE sets interest rates, we’re really just talking about one particular interest rate – the ‘bank’ or ‘base’ rate. This is the level of interest the BoE pays to commercial banks on their deposits.

It’s important because lots of banks price other loans from the base rate. A loan’s interest rate is usually said to be “base rate plus x%”, so if the base rate falls so does the interest rate on these loans.

Negative rates also mean rather than receiving interest on their deposits at the BoE, commercial banks would have to pay to leave money there.

Having to pay to leave money in a bank seems strange, and certainly makes saving less attractive. The idea is to encourage banks to take cash out of the central bank and lend it to businesses and consumers, which should stimulate the economy.

Why do they matter for the stock market?

What’s true for banks is also true for companies and individuals. If you’re being paid less interest, there’s less incentive to save and you’re more likely to invest the money or spend it.

More investment by the general public increases demand for shares, which is good news for share prices.

Meanwhile access to cheap debt encourages companies to borrow money and invest in new factories, sparking growth in the economy. So to some extent, negative rates are just an extension of classic monetary policy. Lower rates boost the economy and higher rates help to stop it overheating.

There are downsides to cutting interest rates though. When UK interest rates are low (or even negative) that negatively affects the value of the pound. Because international investors receive less interest on their sterling holdings, the pound’s value will fall relative to other currencies.

That can cause problems for companies that sell imported products in the UK, electrical retailers for example, since the price of stock increases. It can also drive short-term increases in inflation, making consumer goods more expensive and restricting spending.

Central bankers have a difficult balance to achieve.

Why are negative rates a particular problem for banks?

There’ll be winners and losers from negative rates. One sector that would find lower rates particularly problematic is the banks.

Banks make money by borrowing money at one interest rate and lending it out at another higher rate. The money they borrow is largely in the form of customer deposits – that includes high street customers’ current and savings accounts as well as longer-term bonds.

Negative rates have the potential to disrupt this model.

As we mentioned earlier, lots of loans have an interest rate which is “base rate plus x%”. So a lower base rate automatically means a cut in the overall interest rate borrowers pay. Because banking is quite competitive – when you take out a mortgage you usually have several options and probably just opt for whichever is cheapest – lower rates usually get passed onto new customers too.

However, just as banks themselves are likely to move money out of the BoE if interest rates turn negative. Consumers are unlikely to leave savings in a bank account if they have to pay for the privilege.

Interest rates on bank accounts are already low, and zero in some cases. Banks need customers’ money to stay in accounts if they’re going to have enough cash to lend out. That probably means they’ll struggle to push interest rates on savings into negative territory. If banks started charging customers to look after their money, it’s likely a lot more of us would start carrying cash.

Put all this together and banks face the challenge of falling interest rates on loans, but stubbornly static rates on savings. Essentially revenues have fallen but funding costs are still the same. That would be very bad news for banking profits.

Although falling rates have been squeezing banking profits for a while, negative rates have the potential to make things much worse. That probably explains why banking shares are trading at a fraction of the theoretical value of their assets. Investors are worried banks will struggle to make a profit from the loans they make.

How should investors react to negative rates?

The BoE’s reluctance to introduce negative rates means it would be a sign the UK economy’s in a bad way if they did materialise. However, while there are some obvious losers, it could actually be good news for share prices generally. That makes it a difficult challenge for investors to negotiate.

There are no easy solutions, and how you invest probably comes down to your personal opinion on how likely you think a fall in rates is. There are some steps you can take to help shelter yourself from the worst effects though.

Firstly, check how much you have invested in banks. Historically the sector’s been very popular with retail investors because they’ve paid big dividends. Lots of these dividends were scrapped in 2020, and investors could have too much invested in the industry.

Secondly, make sure you’re diversified outside of the UK. Relying on currency movements is notoriously risky, but having everything invested in UK companies means you’re very exposed to the success or failure of the pound. If interest rates are cut, we would expect sterling to fall as well and that would be good news for investments denominated in foreign currencies.

This article isn’t personal advice. If you’re not sure if an investment is right for you then ask for advice. Unlike the security offered by cash, investments and any income they produce can rise and fall in value, so you could get back less than you invest.

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