Negative interest rates – what do they mean for investors?

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

Earlier in September minutes from the Bank’s Monetary Policy Committee (the committee responsible for setting interest rates in the UK) seemed to suggest it was seriously looking at negative rates for the first time. That sent markets into a bit of a spin.

The Governor of the BoE has since said negative rates aren’t on the cards any time soon. But what are negative rates and what do they mean for investors?

This article isn’t personal advice. If you're not sure what’s right for your circumstances, please ask for advice. Unlike cash, all investments and their income fall as well as rise in value, so you could get back less than you invest.

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 often 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 that, 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 crazy, and certainly makes saving less attractive. The idea is that this would encourage banks to take cash out of the central bank and lend it to businesses and consumers, stimulating the economy.

Why 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 on consumer goods and services.

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 help to 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 usually falls relative to other currencies.

That can cause problems for companies that sell imported products in the UK – electrical retailers are a classic example – since the price of stock increases. That can also drive increases in general 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 will be winners and losers from negative rates – however, 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 longer term bonds.

Negative rates have the potential to disrupt this model.

As we discussed at the beginning of this article, many loans have an interest rate which is “base rate plus x%” – so a lower base rate means a cut in the overall interest rate customers 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 are likely to move money out of the BoE if interest rates turn negative, consumers are unlikely to leave their savings in a bank account if they have to pay for the privilege.

Interest rates on bank accounts are already incredibly low, and zero in some cases. Since 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 the red.

Put all this together and banks face the challenge of falling interest rates on loans, but stubbornly static rates on savings. Essentially revenue has fallen but funding costs remain unchanged. That would be very bad news for banking profits.

Although falling rates have been squeezing bank profitability for some time, negative rates have the potential to make matters far worse. That probably explains why banking shares are trading at a fraction of the theoretical value of their assets. Investors are worried that banks will increasingly 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 that the UK economy’s in a bad way if they did. 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 we are to see rates fall. However, 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 in the past they’ve typically paid sizeable dividends. However that means lots of investors could have too much weighting to the industry. Given banks have been ordered to scrap dividends this year, this could be an opportune moment to consider shifting some investment to other sectors.

Secondly, make sure you’re diversified outside the UK. Relying on currency movements is notoriously risky, but being only invested in UK companies means being 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.

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