Despite the Federal Reserve raising its overnight rate in December, an increasing number of people are now calling for the Fed Fund rate to go negative. The chatter around negative rates has become so loud that Janet Yellen addressed the issue on Wednesday saying that while there may be legal issues with lowering rates below zero, the central bank can likely do it if it wanted to.
The hope is that negative rates will force banks, which store money at the Federal Reserve, to spend their cash rather than pay the central bank to keep it. That would in turn spur the economy. But what often gets lost in this discussion is what happens to the average investor — and the outcome isn't pretty.
In theory, falling interest rates should increase stock markets — and low rates over the past few years has boosted equities. That's because when rates drop, investors have to buy stocks — and usually high-yielding ones — to make any money. However, that's not what's happened in regions that have already gone negative.
In June 2014, the European Central Bank's deposit rate was cut to –0.1 percent. Since then, the iShares MSCI EMU Index ETF — a security that tracks an index composed of large- and mid-cap companies located in euro zone countries — is down nearly 30 percent.
Since Switzerland imposed negative rates in December 2014, the iShares MSCI Switzerland Index ETF has fallen by about 14 percent. Sweden entered minus territory in February 2015, and its market has dropped by 20 percent. The only market to see a gain since introducing negative rates is Denmark, with the iShares MSCI Denmark Capped ETF up 94 percent since July 2012.
Of course, the U.S. is far larger than many of these markets, so what happens there may not happen here, but John Lonski, chief capital markets economist at Moody's Analytics, is of the view that stocks will drop if rates fall below zero. Why? A big reason is that negative rates do not instill confidence in the economy, and if people are nervous, they won't borrow and spend, he said.
In theory, negative rates should make borrowing more attractive, both for consumers and businesses. Other than the banks, who have to pay to store their money at a central bank in a negative-rate world, other borrowers will just get loans at ultra-low rates. (It's unlikely that financial institutions will make people pay for storing money in an account unless they want to risk a run on the bank.)
However, if people think the economy is tanking, they may just keep their money safe in a bank account instead of spending it on goods and services. If they do horde cash, then company earnings will fall, taking their stock price down with them. "The mere talk of negative rates could discourage businesses and consumer from spending as much as they would," he said. "That could depress earnings."
Another problem is that low rates have made stocks more expensive than their historical average, which means that equities as an alternative to bonds isn't as attractive as it once was. Sure, someone can still get good dividend payouts, but they're now paying more for those companies, which increases risk, said Nick Nelson, head of global and European equity strategy at UBS.
That higher risk may make people think twice about jumping into equities in the way they did after the recession, when rates were slashed. "Many people are being pushed up the risk spectrum," he said. "The market is in a stretched situation, where bondlike equities are trading at very expensive valuations."
If the stock market does rise, it will have a lot to do with share buybacks, he said. In Q4 2015 so far — and with more than 100 businesses still yet to report — S&P 500 companies spent $144 billion on share buybacks, up from $129 billion in all of Q4 2014. If borrowing costs get low enough, more companies will simply issue debt and use that money to buy stocks. This is attractive for dividend-paying companies, who would then only pay dividends on a fewer number of outstanding stocks.
"[Dividends] are considerably higher than what most companies can borrow at," said Nelson. "If a company's cost of borrowing is lower than the dividend yield, then they could re-gear their balance sheets by issuing debt and buying back shares."
Savers are also at a big disadvantage in a negative-rate environment. It's hard enough to make money in a savings account today, but if rates are effectively zero, then it will be impossible to generate any return on cash. That means that either people just won't be able to save enough or they'll have to take on more risk than they may like, said Lonski.
What should an investor do in negative rate environment? Ashwin Alankar, Janus Capital Group's global head of asset allocation and risk management, said to hold more money in cash. Despite it not making much in a bank account, it the U.S. goes negative, the global economy will be thrown into such uncertainty that putting money into anything else is a risk.
"We're navigating waters we've never traveled on before," he said. "So it's not the best time to load up on risk. You might think that it would be stupid to say 'cash is king,' but cash is king when your other option is taking on too much risk in the markets and where there's no academic theory on what happens when rates go negative."
If that seems too drastic of a measure, then stick to "safer" equities, like large blue-chip stocks, such as Procter & Gamble — something that has minimal exposure to business cycles, said Lonski. Nelson suggests staying as diversified as possible and looking at other asset classes, like physical real estate. "It forces people to think more about diversifying," he said.
The best piece of advice, though, may be to just buckle down and hold on. The world has never been in a predominantly negative interest-rate world, so no one's quite sure what will happen. "There's not a lot of historical evidence to learn from," said Alankar. "We have to see how it plays out."
— Bryan Borzykowski, special to CNBC.com