The Independent Market Observer

Negative Interest Rates in Europe

Posted by Brad McMillan, CFA®, CFP®

Find me on:

This entry was posted on Feb 27, 2015 12:36:00 PM

and tagged In the News

Leave a comment

negative interest ratesLost in the hand-wringing over whether, when, and how quickly the Federal Reserve will raise interest rates, something very interesting is happening in the rest of the world.

In many countries in Europe—including, for the first time, Germanyinterest rates have gone negative. Instead of getting paid to lend money, bond investors are now paying for the privilege of lending. Following that lead, banks have started to charge depositors for the privilege of leaving money at the bank. This is something we’ve never seen before on a large scale.

Strange but true

Imagine buying a car and the dealer saying, “Don’t pay cash. If you borrow $50,000, we will actually pay you $100 per month.” I would certainly take that offer, but I can’t see how any car dealer would stay in business.

When something is too economically strange to be believed, the answer usually involves the government somehow, and the case of negative interest rates is no exception. We can figure out why by looking at supply and demand for different types of bonds, which is largely driven by government policies.

A question of supply and demand

Supply is simple enough. Many of the most solvent governments in Europe are simply issuing fewer bonds than they have in the past. That smaller issuance, combined with the maturing of existing bonds, means the supply is shrinking. A shrinking supply, with constant demand, would mean prices should rise and interest rates should drop. That, however, does not explain why investors would willingly pay to lend.

Which brings us to the demand side of the equation, and here the key word is willingly. Major demand sources aren't in the market because they expect to make money. One major source of demand is banks, which are now required to hold large amounts of government debt or similarly “riskless” securities. Those regulations have created demand.

Another large component of demand is the European Central Bank’s quantitative easing bond buys, which are explicitly designed to drive prices up and interest rates down. These buyers are not price-sensitive but required to be there—which allows prices to go as high, and interest rates as low, as policymakers want.

Traders are a supporting factor, as they are in the market willingly and intend to make money. They are either counting on the ECB to succeed, which means they’ll benefit from the rising prices of bonds, or on the continued depreciation of the euro against other currencies. They are buying into the trend but aren’t there for the long haul. Although they are helping drive rates lower now, they could easily reverse at some future time, unlike the commercial or central banks.

Do the markets expect deflation?

The final factor here is the most concerning: negative rates make sense if the market expects continued deflation in European countries. Even if you are paying to lend, if prices in general are falling faster, you can still increase your purchasing power. This is a very disturbing signal, if true.

Overall, it looks like the major issue here is constrained supply and regulatory demand. This is a symptom, not a cause, of weakness—something to watch but not obsess over. The time to start worrying will be when the central banks stop buying, or the banking regulations change, and rates still remain negative. We are quite a ways from that, but we should keep a close eye on the markets for when it does happen.

                        Subscribe to the Independent Market Observer            

Subscribe via Email

Crash-Test Investing

Hot Topics

New Call-to-action



see all



The information on this website is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Please contact your financial professional for more information specific to your situation.

Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets.

The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. All indices are unmanaged and investors cannot invest directly in an index.

The MSCI EAFE (Europe, Australia, Far East) Index is a free float‐adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of 21 developed market country indices.

One basis point (bp) is equal to 1/100th of 1 percent, or 0.01 percent.

The VIX (CBOE Volatility Index) measures the market’s expectation of 30-day volatility across a wide range of S&P 500 options.

The forward price-to-earnings (P/E) ratio divides the current share price of the index by its estimated future earnings.

Third-party links are provided to you as a courtesy. We make no representation as to the completeness or accuracy of information provided on these websites. Information on such sites, including third-party links contained within, should not be construed as an endorsement or adoption by Commonwealth of any kind. You should consult with a financial advisor regarding your specific situation.


Please review our Terms of Use

Commonwealth Financial Network®