Negative interest rate policies in Europe and Japan are a likely culprit in the bank rout. The European Central Bank and the central banks of Switzerland and Denmark have had negative policy rates for some time. Given still weak inflation, investors believe they will all take their policy rates further into negative territory. The Bank of Japan recently surprised the market by announcing a negative rate policy after holding its policy rate near zero for two decades. These policy actions reminded investors that many central banks have run out of tried and true tools to stimulate their economies.

This caused long-term interest rates across the globe to fall dramatically and the yield curve – the difference between long-term and short-term yields – to narrow or flatten. A flat yield curve makes it difficult for banks to make a profit on the spread between lending and deposit rates. It also makes it more difficult for insurance companies to offer attractive yields in annuities and other accumulation products.

Interest rate policy divergence adds to volatility*

In addition to upsetting business models in the financial services sector, negative interest rates turn basic assumptions in our financial system upside down. It’s difficult to determine how businesses and consumers may respond in an environment where the banks pay borrowers to borrow and savers pay the bank to hold cash. This uncertainty highlights potential limits of this policy tool.

In contrast, here in the U.S., the Federal Reserve just voted to raise its policy rate in December in response to our relatively strong labor market. New worries about global growth slowing and the responses of other central banks have made investors question whether negative interest rates may spread here should our economy falter. As market participants incorporated new possibilities into their thinking, the stocks and bonds of U.S. banks were caught in the downdraft.

Monetary policy divergence among the U.S., Japan and Europe was our number one cause for concern about volatility coming into the year. Unfortunately for the market, the surprises regarding the impact of policy changes in the U.S. and abroad have certainly not disappointed our forecast.