A world turned on its head ...... So how low can they go ?

Monday 30th November 2015

 

A world turned on its head ...... So how low can they go ?

Ref : "Bankers -v- Mattresses" , The Economist" Nov 28th - Dec 4th 2015

For anyone still finding the idea of negative interest rates a little strange (and there are plenty of us), things are likely to get even stranger before the earth tilts back onto its normal axis.

The concept of paying to lend still doesn't compute naturally, and it wasn't so very long ago that the lowest possible interest rate was presumed to be zero  --  after all, why would you let a bank charge you for taking your money when you could always hoard cash, metaphorically if not in actuality stuffing your mattress with banknotes, as the Economist's title suggests ? For the sake of convenience and security, one might pay a small fee, but that would be about it, surely? As it turns out .... not so. 

In practice most retail banks have not yet passed on the cost of lending to their customers, afraid of losing their well of depositors. And if negative rates remain resolutely counter-intuitive in the mind, on an intellectual level they do make a certain sense in extreme circumstances. Driving down borrowing costs to encourage bank lending and investment is both a logical and tried-and-trusted method of boosting a flagging economy, even if rate-cutting cycles have not previously begun from such a low starting-point. Cheap money and increased consumer spending should also provoke some much-needed inflationary pressure, which should be accelerated anyway by a hugely welcome fall in the value of the currency that low rates generally bring about.

The current scenario that has seen rates pushed below zero in much of Europe was something of an experiment, one that has not so far had the dire consequences that some were forecasting. But negative rates were never intended as a long term solution.

When the European Central Bank (ECB) cut its deposit rate from - 0.1% to - 0.2% in September, its boss Mario Draghi told us that "we are now at the lower bound", and yet on Thursday the ECB is widely expected to announce a further cut. The question is, how low can the ECB go, and for how long ?

What the ECB does obviously has ramifications globally, but particularly so for those European nations not part of the Eurozone. Denmark's has set its deposit rate below zero for nearly three years (currently -0.75%) in an attempt to discourage capital inflows that threaten its currency peg with the Euro. Switzerland (current deposit rate also -0.75%) gave up the unwinnable battle of supressing the value of the Sw. Franc by massive intervention in FX markets and decided to tackle the problem by slashing rates. Another nation trying to keep a lid on its currency and promote a bit of inflation is Sweden, where the Riksbank has set its deposit rate at -1.1%.

We ought to note too that the combination of negative deposit rates and a massive bond-buying programme (QE) means that its not just "overnight" money that's trading in the red. Yields on Swiss sovereign bonds are negative all the way out to 10 years. Germany is not far behind, and in fact about one third of ALL Eurozone government debt yields below zero. It's a stat that would have been unthinkable just a few years ago.

You'd think that the kind of headline deposit rates on offer would have commercial banks withdrawing their reserves at their central bank and swapping them for cash. That this has not yet happened can be put down to the logistical costs of running their daily operations should they do so. But presumably there would come a point (or a rate) where they would have to consider it. Similarly, banks may be prepared to absorb costs for retail depositors for now, but what if those costs continue to increase ? Most corporate lenders are already being charged. And since it is also the case that the jury is still out on what the full effects of a prolonged period of negative yields in bond markets might be, we'll repeat the question : how low can they go ..... and for how long ?

In the end, it may come down to one issue that thankfully has yet to raise its head  : ever lower rates are designed (amongst other things) to boost bank lending, but negative rates discourage depositors ...... and banks nervous of disappearing deposits are unlikely to be keen to lend. Even if the prospect of such a scenario coming to pass is a pretty gruesome one, you've got to appreciate the irony.