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Question of the Week - February 29, 2016

Question of the Week - February 29, 2016

Guest Post - Monday, February 29, 2016

What's with all the negative interest rate talk again?

We brought up the topic of negative yields a year ago, when bond yields in Switzerland fell below zero, followed by a similar occurrence in several other European fixed income markets. The first type of negative yield concerned secondary market bonds, where underlying prices moved high enough over par to push the yields-to-maturity so low (remember the teeter-totter of yields and prices having an inverse relationship) that these actually dipped below zero. How this works is, while the actual stated bond coupon interest rate can still be positive, a negative YTM number guarantees a loss on the bonds when they're held to maturity after both interest and price change (price depreciation in that particular case) are added together. The only time such a position makes sense is if, as a shorter-term trade, one thinks rates could go even more negative (moving bond prices higher), there exists a lack of other options for large flows seeking 'safe' assets, or one is compelled to own a certain amount of sovereign bonds due to an investment mandate—such as those held by governments, pension plans, etc. But, based on standard economics, it doesn't make much sense. Nevertheless, almost a third of government debt globally is now trading at negative yields, surprisingly enough.

Negative interest rates from a central bank policy standpoint is a bit different. In the simplest explanation, this happens when the a target short term rate is pegged below zero and/or it can be implemented differently, such as if rates are pegged to zero, but a penalty 'fee' is charged to member banks for holding reserve cash. So, instead of banks earning interest from the central bank on their excess reserves, they're actually paying—so a 'negative' interest rate.

Either way, why do this? The updated part of the answer is that negative rates are an enhanced stimulus, used by central banks when a zero rate policy doesn't seem to be effective enough. For the most part, as noted earlier, it takes the form of an operational/banking consideration. It's counterintuitive to the basic understanding of how banks usually operate, so can be a challenge to wrap one's head around. When you have zero interest rates, rather than rewarding saving (through a regular, positive interest rate), instead you're attempting to push banks, savers and other low-risk investors further out on the risk curve—toward higher-risk investments and loans. It also perpetuates incentives to borrow and take on leverage at extremely low levels, by pulling credit spreads further down. If this isn't enough, and it may not be any more, central banks have to 'punish' banks for not lending enough by charging a fee to keep reserve cash on ice that isn't being lent or put to other productive uses that banks are in business to do.

Will it happen in the U.S.? It's difficult to say. In recent comments, members of the FOMC have mentioned the idea several times, but have been reluctant to identify negative rates as a possible arrow in their quiver. The Eurozone, Switzerland, Sweden and Japan have just implemented the concept over the past year. After promising not to do so, a week later, Japan was the latest in a last-ditch effort to get an economy on track that's been moving in a deflationary stall-speed for several decades.

This concept seems nonsensical to some, but central banks feel there are other side benefits from a negative interest rate. A key one is as a tool to depreciate outright or just suppress the strength of a currency, versus weaker currencies of competing global trading partners. From a currency valuation perspective, being the one nation with positive interest rates in a sea of negative yields creates a carry opportunity that could further exacerbate dollar strength. This might be the ultimate impact of the 'currency wars' discussed so much over the last several years—the race to deflate currencies to enhance exports at the expense of trading partners. As we know, having a weaker currency benefits and a stronger currency penalizes exports—the latter of which the U.S. has been suffering from as of late.

On the negative side, perception could be one of the biggest downsides to the implementation of negative rates—if viewed as a sign of desperation by a central bank with no other ammunition left. After all, when interest rates move to zero, the traditional monetary policy function carried out through the tightening/easing of short-term interest rates no longer works. Key global central banks had already gone through that process, bringing rates to near zero; then came quantitative easing, which included the buying of bonds further out on the yield curve to synthetically manipulate other key rates (those tied to rates for capital goods/autos/home mortgages—QE policy has either been effective or ineffective, based on whom you ask). Negative rates become a more difficult third step, which is why the idea is so controversial.

While negative rates don't appear likely at this point in time in the U.S., as long as GDP growth remains where it is in the 2's, anything is possible. Conditions remain, as Fed members say, 'data dependent'. Debate continues to surround the issue.

Read our Weekly Review for February 29, 2016.

Read the previous Question of the Week for February 16, 2015.

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