Whilst negative interest-rates are not an outright new phenomenon they are being applied right now on an unprecedented scale. As the Bank of England’s Underground Blog reminds us.
one quarter of world GDP now comes from countries with negative central bank policy rates.
There are a load of consequences from this. Let me open with one which is not publicised as much as it should be. It is that interest-rates (and indeed bond yields) are held down elsewhere by the fact that a rise would lead to currency inflows and likely appreciation as they are compared to the negative rates elsewhere. It has become another component of what has been labelled the currency wars. A feature of this has been the way that the US Federal Reserve has progressed at slower than a snail’s pace in raising US interest-rates as we are nearly in June but have seen so far none of the 3-5 interest-rate rises promised at the turn of the year. Interest-rate rises such as they occur are mostly in response to currency crises these days. By contrast Reuters records this.
Ukraine and Moldova cut rates again today, making it 11 central banks to ease in May alone. 53 since start of last year.
How do people respond to negative interest-rates?
Sweden is one of the nations involved and in fact has the lowest rate so far as whilst the headline is -0.5% the Riksbank also has a deposit rate of -1.25%. This week has seen some news which confirms one of the themes of this blog but first let us let the central bankers have a brief moment of fun in the sun. From Sweden Statistics.
In April households’ loans from Monetary Financial Institutions (MFIs) had an annual growth rate of 7.7 percent, which is 0.2 percentage points higher than in March. Households’ loans from MFIs totalled SEK 3 369 billion.
Central bankers around the world will smile at the way that negative interest-rates have led to a surge in household borrowing. The smile gets even broader when they read a little further down.
The increase is mainly due to housing loans, which increased by SEK 217 billion compared to the corresponding month last year, and amounted to a total of SEK 2 758 billion in April. Housing loans had an annual growth rate of 8.5 percent in April, unchanged compared to March.
So all the Christmases of central bankers have arrived at once it would appear. Cutting interest-rates leading to an economic surge? Er well maybe not as the Shaun critique comes into play. Remember my posts on savings where I have argued that lower interest-rates makes some save more? Well on Monday we got evidence of that.
Households’ financial savings, new savings minus increase in debt, amounted to SEK 58 billion during the first quarter of 2016.
Yes you did read that correctly as the Swedes were net savers in the first quarter of 2016. This is where they put the money.
Households mainly saved in insurance and deposits and made net sales of shares and funds. Net deposits, mainly in bank accounts and tax accounts, amounted to SEK 38 billion, a record level for the first quarter.
The increase in bank savings ( SEK 23 billion) back my argument that cutting interest-rates leads part of the population to save more not less. This offsets the conventional view which only seems to look at the increased borrowing and in this instance ignores the fact that there is net saving going on. Also the plan to get people to shift in to assets seems to be working for houses but not investments “net sales of shares and funds.”
Accordingly we see a complex situation which on the surface seems to back what we might call central banking economics 101. But once we go below the surface we see a familiar argument which is that yes it “works” but that there are offsetting forces which yet again appear to be larger. No wonder central bankers do not always get what they want and struggle to get what they need as well.
They do not apply everywhere
We do not have to step back that far in time to discover a different view of the world from a man who was responsible for much of the work in the derivatives world which provided my occupation and job. From the Bank Underground blog.
n 1995, Fischer Black, an economist whose ground-breaking work in financial theory helped revolutionise options trading, confidently stated that “the nominal short rate cannot be negative.”
You could argue he was already wrong although equally you could argue that Switzerland in the 1970s was a tax on cash especially for foreigners. However let is move on with a number which was not supposed to happen.
According to the BIS, the total notional outstanding of global FX, interest rate and equity-linked derivatives rose from $72 trillion in 1998, to $522.9 trillion in 2015. ( BIS = Bank for International Settlements).
Remember when as the credit crunch hit we were promised that this sort of thing would be curtailed? Perhaps that is why one of the main players, Deutsche Bank, remains so troubled. If we move on we see that there is a link between this and negative interest-rates.
The vast majority (nearly 80%) are interest rate derivatives whose theoretical underpinnings are often predicated on the assumption that risk-free rates are bounded at zero. These baked-in assumptions have made it more complicated for financial markets to adjust to life below 0%, particularly where derivatives were priced and risk-managed as if negative rates were not possible.
That needs to sink in as a group of highly paid people who were are so often told need to be paid so much because they are the “brightest and the best” see their intellectual Titanic hit the rocks and in some cases hard. There have been some technical fudges to help deal with the consequences of this but the market based response was fascinating.
The obvious hedge was to protect oneself against lower rates and higher volatility, for instance by buying bonds, entering interest rate swap contracts, and buying options……However the process of hedging likely amplified the fall in yields,
So problems with negative interest-rates helped lead to negative bond yields! What could go wrong?
Floating Rate Notes (FRNs)
These have had their Houston we have a problem moment.
Legal and operational practicalities have meant FRN coupons are effectively floored at 0%.
Ah, more signs of “genius” at work. This provides yet another problem for central banking 101.
This 0% floor is important. As noted by Ippolito, et al (2016), FRNs are a significant channel through which the monetary policy transmission mechanism works.
Or rather they are not in this instance. The companies involved also have some Taylor Swift style “trouble,trouble,trouble.
But companies must contend with the prospect of having the cost of their FRN liabilities floored at 0%, whilst seeing returns on investible assets fallbelow zero.
This is mostly an issue in the Euro area right now and here is an estimate of the scale.
At present, €350bn of euro-denominated FRNs referencing Euribor (28% of total outstanding) are affected by this 0% floor. If Euribor falls by a further 25bps, we estimate that around half of all EUR FRNs would be affected (~€670bn).
There is more than a certain irony in the fact that the group who were the supposed experts on interest-rates have been proven spectacularly wrong. We have gone where they argued we could not go. I remember the arguments in the late 90s as I was there but what troubles me the most was the failure to adjust post 2007 which is nearly a decade ago now. We see so little thinking and planning ahead and accordingly the “experts” suffer so many surprises.
What we suspected and believed on here was that negative interest-rates would have a succession of unintended and unwelcome consequences has proven to be true. This matters increasingly as I note this from Robert Skidelsky in Wednesday’s Guardian.
Enter negative interest rate policy. The central banks of Denmark, Sweden, Switzerland, Japan, and the eurozone have all indulged. The US Federal Reserve and the Bank of England are being tempted.
The latter section caught my eye as is they way he was described. Do you think both he and the Guardian had forgotten he is Baron Skidelsky and could not be much more well-connected?