A Positive Outlook on Negative Interest Rates: Raising Capital During a Recession
President Donald Trump’s most recent call for a reduction in interest rates cites the coronavirus pandemic as the reason America is in dire need of expansionary monetary policy. This shouldn’t come as a surprise, as zero-to-negative interest rates have been a part of his plans since last September to accelerate US economic growth and— perhaps more importantly— to boost his approval ratings.
His wish came true when the Federal Reserve announced its emergency maneuver to cut the federal funds rate target down to 0% to 0.25% in addition to a $700 billion USD quantitative easing program. If Trump is correct in his vision for the US economy, then this is a massive win.
Somewhat paradoxically, however, the last time Americans saw interest rates drop to 0% was in 2008, in the midst of the Great Recession. To further complicate matters, in 2015 when Reserve Chair Janet Yellen finally decided to raise the US policy rate back up, the Bank of Japan and the Sveriges Riksbank instead dropped theirs a second time, implementing negative policy rates. This of course prompts founders to ask: would negative interest rates be good or bad for startups? The answer, as it often does in positive economics, depends.
The thesis behind a negative policy rate is that the negative interest rate causes investors to be penalized, rather than rewarded, for holding money in safe assets. This stimulates expenditures as well as investment in risky assets. These assets, in exchange for their volatility, offer higher returns than money left sitting in banks or safe assets. Among risky assets, the greatest yields come from venture capital, especially angel-seed and early stage, where private equity investors can pick out promising companies before they catch the public eye. From the founder’s perspective, this means an abundance of available capital. Over the past decade, both American and European venture capital investments have enjoyed steady and substantial growth. When banks and treasury bills are paying negative yields, even a relatively risk-averse investor would have little difficulty committing to a startup in an environment with ideal growth conditions.
The caveat is that in the United States, low interest rates are not usually accompanied by ideal growth conditions. Having learned its lesson from the Roaring Twenties into the Great Depression, the Federal Reserve utilizes interest rates countercyclically to minimize the shocks from bubbles and runaway inflation. Meanwhile in Sweden, the rates have risen back to non-negative zero due to mounting concern over the long term effects of the negative policy rate. What is actually happening now is that, despite the US treasury rate falling into negative territory last month, many investors are still hesitant to place their bets on the naturally-risky startup asset class during this period of uncertainty. The result, whereby investors opt for highly-liquid assets such as gold instead, is called a liquidity trap.
Fortunately, the liquidity trap is built to catch only a certain type of investor, one which founders probably wouldn’t want to partner with anyways. The reason for the current shortage of venture capital for startups is that many speculators who bought in during expansion, with the goal of generating profits through trading, cannot continue to do so during a period of recession, when the expected returns are negative in the short run. Following this exodus, the remaining investors are those who rely on fundamental analysis (industry and firm-specific knowledge) to identify promising firms and partner with them in the long run. This quality-over-quantity method might not operate at the same volume as mass speculation, but it is becoming increasingly popular as high-frequency trading technology has outpaced human technical analysis (numerical analysis of trading data) ability. A high-quality investment is much more likely to ride out the business cycle, and historically most of the fastest growing companies in the US were founded during a recession.
From a more macroeconomic perspective, a negative rate policy would also have implications on international financing. Suppose the Federal Reserve did drop its federal funds rate below zero. In order to avoid capital depreciation, Americans would be incentivized to hold cash rather than safe assets. Suddenly, there is an excess supply of unused US Dollars. Startups in Sweden, with its newly hiked rates, might thus benefit from directly sourcing capital from the US as opposed to their own country where the currency is relatively strong. If not, American investment in Riksbank treasuries would still increase the available capital in the home country. As an added bonus, the price of USD would decrease on the foreign exchange market, so one SEK can purchase more American goods.
As a monetary policy tool, interest rates more so reflect the state of the economy than determine its trajectory. Whether a negative policy rate would be good or bad greatly depends on a number of factors, including (but certainly not limited to) country of origin and destination, historical rates, and what type of investor one wants to attract.
“Great companies will get funded,” says venture partner Ben Capell. “Soft companies that rely on capital and bad unit economics are kind of toast in this environment.”
The Qvantea team recommends that founders take time during this global lockdown to build the foundations of a great company, one that will ride out this recession and emerge triumphant. Trough or peak, we’re here for you.