Mar 9, 2016

How a Negative Interest Rate Regime will Destroy the Banks (And Your Investments)

8 years after the global financial crisis, inflation and economic growth remains elusive after years of 0 interest rates and numerous rounds of quantitative easing. As the pillars of global growth of India and China start to slow down in the past few months, central banks in Japan and Europe push their monetary policies to a new frontier: Negative interest rates.

Normally, a loosening of the monetary policy will lead to a fall in the country's currency (foreign investors will pull out their deposit and seek better yield elsewhere) and a spike in the stock market (local investors find it expensive to park their money in cash and choose to invest for yield). However, the recent monetary policies from Europe and Japan lead to a rise in their currencies and a steep drop of their stock market, with banking stocks bearing the brunt of the selling. How did this abnormality occur? Let me explain why.

The idea of negative to the general public is simple, park cash with the bank and you get a penalty fee (negative interest) rather than the normal interest which you will get. However, central bankers conveniently overlook one important point about cash: You do not need to park it in the bank.

The general public can stash their cash under their pillows, in metal tin cans or within their personal safe with no penalty to the value of their cash and at the same time maintain their spending power. For the banks however, this will come at a great disadvantage to them as they are unable to stash their cash under the pillow and it is difficult and costly to store physical notes in giant vaults. They have to set aside their savings, also known as cash reserves with the central banks which they will be losing money every single day due to the negative interest rates and it does not help that the banks are required to set aside more cash reserves after the global financial crisis. On top of that, the bank can barely make any profits from the interest rates differential due to the negative interest rates as banks now are unable to borrow money at negative interest rates (due to deposits being pulled out), keeping their absolute borrowing cost at 0% while having to lower the lending rate, squeezing their profit margin.

The negative interest rate experiment lead to fears of another bout of fear on the health of global banks given that banks are still recovering from the global financial crisis while being trapped in a never ending wave of increasing regulatory cost and civil lawsuits.

There is an initial euphoria in the financial markets when the Bank of Japan first announced a negative interest rate cut but the Japanese stock market fell afterwards and the Yen shooting up resulting in an exactly opposite result which the BOJ is hoping for.

With this in mind, all eyes turned to the EU central bank as they meet on the 10th or March to discuss on monetary policy issues. There has been claims that the ECB still has ammunition available to stoke growth and to revive inflation in the EU zone and the world is wondering what other innovation that the central banks have up in their sleeves other than a potentially disastrous negative interest regime.

Portfolio Performance

The portfolio is down by -1.16% for cash compared to the -2.4% for the MSCI All Countries Index for the month of Feb. The portfolio performance will have been even better if not for the strengthening of the SGD against major trade currencies. The main reason for the surge in SGD and other ASEAN currency is a sharp inflow of funds into the region as Asian focused investors redirected their funds from north Asia whereby there is still huge domestic middle class market in ASEAN not affected by the slow-down in China yet. The ASEAN stock market, led by Indonesia and Thailand are two of the best performing markets in the world as of now and are generally unaffected by the January crash. However, I believe that the rally to be short lived as the impact of a China hard landing will gradually affect the domestic markets of ASEAN.

With Energy and commodity prices at a low and a potential slow-down in the monetary tightening in US due to a slowing global economy, Resource and material sector looks increasingly attractive after being the underdog for the past 4 years and it may be profitable to dip our toes into it. No doubt material prices will take another knock down should there be inevitable bad news coming from China again but the downside should be limited for now. I will be making a switch to a more conservative portfolio now that the markets has rallied strongly from the recent Winter fall as more turbulence is expected down the road.
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