Why negative interest rates: A dangerous weapon

In an effort to support the real economy and protect the banking system, policy makers are unwittingly conducting a war on market liquidity — thereby ensuring that they will fail to achieve their stated goals.

The latest weapon in the arsenal of central banks — deploying negative interest rates — represents a major escalation with dangerous consequences.

To avoid a full out war of their own making, policymakers would be wise to refresh their memories on how the first shots were fired in the war on liquidity and better coordinate efforts going forward.

Michael Nagle | Bloomberg | Getty Images

Traders work on the floor of the New York Stock Exchange (NYSE) before the U.S. Federal Reserve interest rate announcement in New York, U.S., on Wednesday, Jan. 27, 2016.

As we all know, the collapse of Lehman in 2008 led central banks to enter the brave new world of "unconventional" monetary policy, launching large-scale QE programs. By effectively lowering interest rates, these programs encouraged investment in corporate bonds and stocks—which resulted in a commensurate rise in stock prices.

Meanwhile, banks responded to new regulations that raised their capital requirements by withdrawing from their historical role as short-term providers of liquidity to the capital markets.

The result? Not even the U.S. Treasury market was spared periodic liquidity vacuums and the war had begun.

While QE helped the world avoid a deep and protracted slump, it has not delivered strong and sustainable growth or banished the specter of deflation. With new threats looming—weak emerging-market growth, a possible hard landing in China—central banks deployment of negative interest rate policies (NIRPs) is only going to exacerbate, not de-escalate the war on liquidity.

The consequences of negative interest rates

Why?

Although negative rates have helped push bond yields lower, we doubt they will achieve their broader aims. In fact they could derail growth and endanger banks. NIRPs essentially use the same three monetary-transmission channels as QE: the exchange rate, asset prices and bank lending. We question the efficacy of the first two channels and fear the third could work in reverse.

First, when other central banks are employing similar strategies, the exchange-rate channel is unlikely to be effective—as the yen's recent rise demonstrates. Second, the impact on asset prices is becoming subject to diminishing returns as investors question their ability to manage asset volatility in a falling liquidity environment.

But it's the third channel, where the greatest problem lies. That's because ultra-low and/or negative interest rates, impinge on banks' net interest margins (NIM), an important component of banks' future capital base. Combined with the impact of even more stringent regulation, this reduces a banks' willingness to lend to borrowers and further impairs their ability to provide liquidity to markets.

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In short, NIRPs look like a dangerous weapon with potentially unpredictable and undesirable collateral damage to market liquidity and financial stability.

The war on liquidity is at a critical tipping point that calls for a cease fire and coordinated de-escalation by the monetary and regulatory areas of central banks. Without coordination across policy, in their efforts to sustain growth, avoid deflation and safeguard the banking system, central banks are in danger of igniting the kind of war they are meant to prevent.

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Commentary by Ashish Shah is head of Fixed Income and Doug Peebles is CIO of Fixed Income at AllianceBernstein.

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