Central Banks, Negative Interest Rates, and the Threat of Deflation

There were a record number of hedge funds reporting results far underperforming the S&P 500, and some even closing down. Ackman went as far to blame everyone and everything about his poor performance, Einhorn’s longs crumbled whilst his shorts (Netflix and Amazon) rocketed. It’s a pretty bad time to be a hedge fund manager.

One chief complaint is on central banks. You see, hedge funds in general make bets on security prices due to prevailing market sentiments or mispricing of securities. If you tend not to believe in the efficient market hypothesis, then you’d know that if the hedge funds are right, slowly but surely, the market will wake up to that mispricing and re-price it more efficiently, netting the astute investor a nice profit.

But what’s been happening over the years are central banks’ interruption of the usual market ebb-and-flow by intervening in almost everything; as you can imagine, it has been devastating for hedge funds. Your bets suddenly turn sour just because some central banker from a different country said something vague and the markets go crazy because they can’t interpret his words. Take the US Federal Reserve for example, on Monday you can have Bullard saying something bullish and the markets rocket, Wednesday Lacker comes forward and goes “no, no, no, that’s not what he meant” and the markets fall, Friday Kocherlakota comes out and says something weird, the markets rocket yet again.

Much can be said about the Fed’s forward guidance policy but it isn’t helping the market at all, it makes investors (both pros and amateurs) myopic and obsessed about every word they say and miss out on the bigger picture. Why wouldn’t they? The Fed essentially moved the markets at every turn (and will now have to contend with the Chinese), it’s only natural to want more… like a drug. This policy has made more people addicted to the hopium.

However, the markets aren’t stupid and are getting more skeptical on central bank actions. The most recent example was the markets sending the Yen soaring despite the Bank of Japan (BOJ) suppressing Japanese government bond yields to negative, smashing Japanese stocks at the same time. This isn’t what the BOJ is looking for and if the Yen strength continues, one can expect a very high probability of the BOJ intervening again to weaken their currency.

All around the world, central banks are no longer happily racing to zero but to negative rates. All that ZIRP-ing and NIRP-ing has created a unique and unprecedented situation where investors are at complete loss on where and how to allocate capital to achieve returns.

Many commentators have pointed out that this is an aggressive currency war played between major economies to jumpstart growth. However, I believe that it isn’t a matter of war but survival. The key threat to all major economies is deflation. Central banks may be manipulating their currency to remain or gain competitiveness, but the sense now is that they’re desperately trying to avoid deflation and slowing growth. Endless American politicians and businessmen railed at China for keeping the Yuan artificially low, and when China devalued in August 2015, the same people weren’t shouting. Why? They knew that China wasn’t so much fighting but trying to survive, and many investors smelled blood and raced in.

The way the markets reacted to the BOJ has also shown that people are now skeptical of central banks and their policies might not be as effective as before, thanks to the law of diminishing marginal utility. How much more creative can central banks get to not appear desperate and to solve deflation? This dilemma faced by central banks is a dilemma faced by all investors.

We have no idea the implications of prolonged negative rates to the global economy and market in the long run but it’s worth looking at the obvious to try to extrapolate a somewhat clear view on where we stand:

Financial Industry

Banks are the first to get hit when central banks manipulate interest rates. In general, higher interest rates prove more profitable for banks as their net interest margin (NIM) increases: the rate upon which banks earn interest on loans over interest paid to depositors. Countries with higher rates would see their banks earn fat margins, one fine example would be Singapore.

DBS and OCBC reported sizeable earnings recently due in part to the sharp spike in the SIBOR/SOR as it mirrored the Fed rate hike. To see the tangible effects of rate rises, watch for competitive fixed deposit rate wars between the banks around you, that’s how they fight for your cash. On the flipside (and ugly), loans like mortgages pegged to SIBOR/SOR would feel the full brunt of its increase. DBS and OCBC’s thus NIM widened despite the rise in non-performing assets stemming from the oil and gas sector.

Insurance companies holding floats made up of mostly bonds would see sizeable capital gains on their bond prices, marking their assets higher to the market, but reinvestment risk (which is key to bond investing) runs high as they would then earn paltry returns on their investments. A rate rise could ruin their party any time.

Capital Flows

By going negative, investors and banks would have to pay the government money to buy and hold their bonds. Why would one want to pay more money to the government? Aren’t taxes bad enough?

The implication then, is that investors who’re domiciled in a country with negative rates would seek capital refuge in countries with higher interest rates. Capital gets sent en masse to places like the United States where its economy is growing, inflation tepid and perhaps the only major economy in the world that has risen rates recently. This heightens the risk of asset bubbles as hot money floods the market. Negative rates somewhere could mean asset bubbles elsewhere.


The main aim of central banks using implementing a NIRP is to sustain or spark inflation. The world is in a deflationary cycle since the start of the 2008 crisis as everyone tries to deleverage. Singapore is currently having no inflation whatsoever and we even went into deflation mode recently.

Cash is king in deflation. Asset prices tend to stagnate or decrease in a deflationary cycle, and one’s purchasing power actually increases in a deflation.

Investing in high quality blue chip stocks with low dividend payout ratios could prove prudent as the dividends (if they aren’t cut) would give increased inflation-adjusted returns to investors.

Also, if you have invested in relatively safe bonds and have no plan on selling before maturity and/or the bond having no early redemption option by the issuer, you’d be doing well.

On a personal level that is all fine and dandy but imagine being on the other side of the trade: the issuers. They now have to pay more in interest as it becomes more expensive in a deflationary environment. This increases their chances of not seeking out loans as they wait for even lower rates, thus curtailing investments in their operations, stymieing growth and the overall economy.

Economic growth is based on transactions – spending. Imagine this, that item you’ve been eyeing suddenly costs 5% less than a week ago, but you know that if deflation continues, you’d hold off on buying that item until it comes down to a significantly more attractive price. Sir Isaac Newton once famously quipped, “I can calculate the motion of heavenly bodies but not the madness of people”. Humans tend to think in herds and this herd mentality will cause a further downward spiral on prices, exacerbating the problem and reinforcing their beliefs. The economy will shrink at a rapid pace if no one steps in to stop this negative feedback loop. Now you see why central banks are so desperate.

Furthermore, deflation doesn’t exclusively affect prices, it creates a downward pressure on wages as well. Everything is relative to each other and a deflationary environment will cause a structural shift in the way companies, industries, markets and central banks operate.

The Fifth’s Perspective

Do not try to predict central bank actions. They are highly unpredictable and any deviations could cause price swings that most investors can’t stomach (SNB’s removal of the Swiss Franc floor). Even by not doing anything, central banks’ interventions can still adversely affect you. It is best we as average investors allocate capital prudently in high quality companies and/or short-term, high quality bonds should deflation be more prevalent in our country.

Matthew Lim

Matthew Lim is an equities and fixed income investor. He has a great curiosity of how markets, economics, and human behavior influence each other. He believes that an understanding of human irrationality and solid fundamental analysis allows an investor to seize opportunities and ultimately profit from the market.


  1. Excellent article. I’m recommending your site to others. I’m amazed how many people mainly think of property when it comes to investment, with an “the only way is up” view to value. Sure that can be the case in the long-term, but deflation is a real danger here in Singapore right now, especially as property looks awfully expensive in the context of current to medium term yield prospects.

    1. Thanks Jonathan! That’s the biggest kind of endorsement we can receive from our readers 🙂

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