The Reserve Bank of New Zealand signals another major move: with negative interest rates imminent, where next for asset allocation?

In its August Monetary Policy Statement, the Reserve Bank of New Zealand listed negative interest rates—lowering the OCR below 0%—as a monetary policy option and further clarified its intention to implement them.

Since the start of this year, the Reserve Bank has repeatedly signalled that it is considering negative interest rates. Early in the year, it sent enquiries to New Zealand's major banks asking for their views on negative rates and whether their internal systems could accommodate them, as many systems assume interest rates must be at or above zero.

Although negative interest rates are unconventional, they are not unprecedented. European countries and Japan entered, or have experienced, periods of negative rates following the 2008 financial crisis. So what exactly are negative interest rates?

How OCR changes affect the public

Before explaining negative interest rates, let us look at how changes in the OCR flow through to commercial banks and the wider public.

The Reserve Bank of New Zealand reviews the benchmark interest rate 8 times a year and decides whether to adjust the OCR based on those reviews. The smallest adjustment is 0.25%.

OCR is essentially the benchmark rate for interbank lending. The current OCR is 0.25%。

For example:

Bank A receives 1,000,000 in deposits today and lends out 600,000, leaving a surplus of 400,000. It deposits this 400,000 with the Reserve Bank and earns interest at 0.25%, the benchmark rate.

Bank B receives 600,000 in deposits today but needs to lend out 1,000,000, leaving a funding shortfall of 400,000. It can borrow 400,000 from the Reserve Bank, then lend that 400,000 at a higher rate to earn the interest margin. Bank B's borrowing rate from the Reserve Bank is 0.75%, the benchmark rate plus 0.5%.

In this way, the Reserve Bank also fixes the range of interbank market rates: rates on lending between banks are confined to 0.25%–0.75%. Interbank rates then influence the deposit and lending rates banks offer their customers.

Suppose the Reserve Bank raises the benchmark rate to 1.25%, an increase of 1 percentage point. Let us again use Banks A and B as examples.

Bank A in the example can now earn 1.25% interest from the Reserve Bank. To remain competitive in attracting deposits, it will also raise its own deposit rates by around 1 percentage point. In other words, the interest we earn on bank deposits, including on-call and term deposits, will rise.

Bank B in the example must now pay 1.75% interest to borrow from the Reserve Bank. With its funding costs higher, it will raise the corresponding rates when lending that money out to maintain its profit. Our borrowing costs for mortgages, car loans, credit cards and so on will therefore also increase.

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What negative interest rates actually mean

Negative interest rates mean that when Bank A in the example deposits money with the Reserve Bank, it earns no return and must instead pay a charge; meanwhile, Bank B earns a return when borrowing from the Reserve Bank, rather than having to pay a charge.

In these circumstances, banks naturally prefer to borrow from the Reserve Bank: they have more funds available to lend and earn an additional return.

One point needs emphasis here: Although the OCR is negative, experience in other countries suggests that retail interest rates will not turn negative, because commercial banks still need to actively attract deposits and avoid bank runs.

Ordinary consumers therefore need not worry about having to pay banks to hold their deposits. Of course, earning a return from a bank when borrowing is also unlikely. Deposit and lending rates will inevitably fall, however, helping stimulate spending and investment.

What effects will negative interest rates have?

A negative OCR affects much more than deposit and lending rates. It will also influence exchange rates, bond investment, the wider financial market and investor confidence.

• It benefits New Zealand's export sector. As funds move towards currencies offering higher interest rates, the New Zealand dollar is very likely to depreciate further.
• Bond investments will lose their appeal to ordinary investors because returns are too low.
• It increases risk across the financial system. Even some large fund managers are currently seeking ways to improve returns on their conservative funds. Low interest rates force them to consider assets with relatively higher risks and lower liquidity.
• Confidence in the economy is relatively subdued.
• For businesses, despite interest rates continuing to fall, many large companies are instead deleveraging and significantly increasing the proportion of cash on their balance sheets. Faced with uncertainty, businesses must first ensure stable cash flow sufficient to handle unexpected events.
• For individuals, many fear losing their jobs or having their income reduced. They worry about their existing funds losing value but are reluctant to invest blindly, leaving them in a difficult position.

How to invest to protect your money's value

Interest rates can be expected to remain low for a considerable time. The Reserve Bank is only likely to consider raising them once the economy has fully recovered. In these circumstances, investors seeking steady returns and protection against their money losing value will have to try relatively riskier assets, such as equity and property investments.

Excessive money creation and low interest rates often drive asset prices steadily higher. During an economic downturn, investing in the real economy carries substantial risks, so more money shifts towards financial assets. The share market offers an appealing destination, with quality shares particularly sought after—such as Apple, currently valued at two trillion. This does not indicate a broad bull market in shares; rather, it reflects investors concentrating their money in quality assets under economic pressure.

But risks rise alongside asset prices, so when allocating assets, investors should avoid blindly chasing price rises. They should fully consider their own risk tolerance and available cash flow, making sensible investments with manageable risks. They should be especially cautious about unfamiliar investment products and ensure they understand them thoroughly before making an investment decision.

About the author:

Uncle Mi

Uncle Mi currently works in financial regulation in New Zealand and is familiar with financial licence applications, AML/CFT compliance and auditing, and fund management and operations. He also runs an independent media account. His WeChat public account mainly publishes original finance articles, combining the current state of New Zealand's financial industry with financial theory to explain everyday financial knowledge in accessible language.