James Bevan: Negative rates – are they kill or cure?
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There’s a strange view beginning to circulate that negative interest rates, as used by the Swiss National Bank, the European Central Bank and now the Bank of Japan, are potentially helpful.
CCLA’s Chairman James Dawnay has noted that Switzerland will hold a referendum to decide whether to ban commercial banks from creating money. The campaign – led by the Swiss Sovereign Money movement and known as the Vollgeld initiative – is designed to limit financial speculation by requiring private banks to hold 100pc reserves against their deposits.
The campaign group has said: “Banks won’t be able to create money for themselves any more, they’ll only be able to lend money that they have from savers or other banks”.
The Swiss federal government confirmed on Thursday that it would hold the plebiscite, after more than 110,000 people signed a petition calling for the central bank to be given sole power to create money in the financial system.
Toxic
Underlining the deep unease felt by many is the problem that negative rates are exceptionally toxic to any country’s banking system, its pension companies and insurers, and most of all its rentiers (who in an era of aging demographics are becoming ever more important).
With regard to the latter and most important group, there is now ample evidence from both the 1970s and much more recently, that suggests that ultra-low/negative rates will lead a population to attempt to save more of its incomes.
Thus alarmingly over the last year (real) interest rate expectations have collapsed in Germany, Japan, and even Italy, and the relevant populations have moved to save more.
The likely explanation is that the people are trying to re-build the perceived net present value of their pension pots, or put another way, they have a target terminal level for their real savings that negative interest rates makes it harder to hit.
‘Saving’ may sound sort of virtuous, but actually saving is in effect deferred consumption. Higher saving, particularly in the context of a period of lukewarm capital expenditure trends, such as we have today, cannot therefore be expected to lead to faster rates of economic growth in the short to medium term.
On this basis, negative rates are always likely to be unhelpful for an underlying economy.
Taking a different tack, negative interest rates have long been recognized by central bankers and bank analysts (if not macro economists) as being toxic for the financial systems of the countries that adopt them, making their recent popularity even stranger.
By way of an example, an industry colleague has advised that the Swiss private bank for which he then worked had witnessed an 85% decline in its profits when the SNB took rates negative, largely caused by the fact that the banks could not afford to pass on negative interest rates to their depositors for fear of losing their financing and hence their businesses.
We cannot therefore see how negative interest rates can be construed to be good news for an economy, let alone its financial system.
Compressed margins
Unpacking the luggage surrounding negative rates, it’s hard to understand how and why proponents argue that negative rates can be expected to boost credit growth when they require banks to compress their margins. If we wanted some data on what happens in the real world when interest rates go negative, the evidence from Switzerland is that credit growth de-celerated.
Equally with Sweden, there is no evidence that credit growth accelerated after rates were taken into negative territory. Instead, there is evidence that the old adage – what is bad for the banks is bad for credit growth – still holds true.
Central banks aren’t populated by stupid people and have full access to all the data that might inform the debate – so it is distinctly surprising that some central bankers have decided to go with negative rates.
It’s particularly surprising with Japan, given their long-held, and oft-repeated concerns over just what negative rates would do to their financial system and even the household sector’s financial position. What, or who, persuaded the change of mind isn’t known.
What has been interesting and worrying over the last few days is that the equity markets which, rather than reacting with Pavlovian habit to the notion that “more central bank action = good for equities”, have responded by marking down bank shares aggressively.
This selling of bank shares has extended even to the US, where some are now predicting that the Fed will be obliged to join the negative rate club. Interestingly US banks are already charging custody fees which seem to be in the region of 1% for $1bn.
Perhaps the most shocking part of the whole negative interest rate game is that despite all of these problems and the disadvantages that accompany a move to negative rates (and the other challenges such as the impact of the ECB’s QE on the TARGET2 system), several central banks seem intent on negative rates regardless.
Motives
As to why this has happened is not clear: they may have been under political pressure; they may have been snubbing the OECD’s recent warnings at Davos that the policy arsenal was empty.
Either way, we may expect that politicians are starting to force the central banks to reach this point and we may suspect that there may be yet another ever more illogical push into even more negative territory by the ECB and perhaps even by the BoJ. But we anticipate that the central banks are very close to being “found out”.
The challenge of interpreting central bank motives and behaviours is clear when we think about the Fed and whether it has eased or tightened.
At one level, this question may seem nonsensical but although the FOMC has raised interest rates and has been obliged to do an extra $200bn of reverse repos per week in order to reduce the amount of excess liquidity in the banking system (i.e. it has implicitly removed between one half and a third of the liquidity that it added in QE3), the fact is that US bank credit growth has accelerated since the FOMC signalled higher interest rates.
The bank credit data were affected by a year-end spike (largely driven by the repo markets) but in general it’s interesting that both the mortgage data and the C&I lending data have started to look better since the FOMC raised rates.
Arguably, this has occurred because the move away from zero has given the commercial banks the prospect of higher margins and therefore increased their willingness to lend.
Certainly, we can argue that given the level of excess reserves that the commercial banks have experienced over the last five to six years, and the banks’ still low loan to deposit ratios, it was never a funding constraint that was limiting credit growth in the US; it may, instead, have been a lack of potential returns to new lending that was constraining the banks.
Instead, we suspect that there was a basic lack of demand for credit from the real economy and a lack of supply caused by both regulators and the very low level of rates that have kept credit growth weak over the last few years. But at least one of these problems has now been eased, with the result that credit growth has picked up to what is now a quite robust pace.
Interestingly, given this outcome, there may be good reason why the FOMC would wish not to move official rates back down (although the still relatively low level of the loan to deposit ratio may of course keep the deposit rate below zero for some time to come).
There is however one complication to the US monetary policy story, which is the US corporate bond markets.
Perhaps, partly as a result of the impact of the fall in the oil price but also as the result of an unintended consequence of the FRB’s reverse repos (which have lowered the demand from the financial sector for corporate bonds to use as collateral), the corporate bond markets have clearly weakened.
Over time, we can expect that this weakness will result in the brokerage community starting to ‘ration’ the access of corporates to the fund raising within the markets, which would represent an effective tightening in credit conditions for not only large corporations but also for the equity markets that have, for much of the last decade, been heavily reliant on the flow of equity-buy-back capital that was itself being funded from the bond markets.
However, given that the FRB was reportedly concerned by the quantum of corporate zaitech that was occurring, we doubt that the central bank will be too concerned by any slowdown in this level of activity.
It can be argued that perhaps the Fed should not have attempted to tighten late last year given the weaker data that is being reported not just by many overseas economies but also by the US itself – but it seems to us that so far at least the net impact of what the Fed has actually done has been to improve the supply of conventional bank credit while potentially curbing some of the excesses that were occurring in the corporate bond markets.
Therefore, whether by design or simple good fortune, the FOMC’s last move could at this juncture be viewed as a success and a reason for the Fed to stay put for the next 6-9 months.
Inventories
On the US economy, although we the US GDP data may have understated actual consumption spending (particularly on autos), problematically virtually two-hundred percent of the reported growth in GDP during Q42015 came from a build-up in inventories.
Certainly, the very high level of the inventory to shipments ratio in the US at present suggests that the next move in US inventories should be a move into negative territory and this may of course be what the recent slew of ‘weaker than expected data’ from the US is telling us.
Clearly, US GDP has a very high probability of disappointing in H12016 and the ‘recession word’ may even start to appear in some circles as inventories are reduced – potentially sharply.
With Europe, at present it is operating with a $350bn current account surplus and its banks are repatriating somewhere between $400bn and $700bn in capital from offshore.
This situation has implied that the cause of the Euro’s weakness over the last year or so must have been the European banks’ reduction in their foreign liabilities with the German and Italian non-bank private sectors purchasing around $450bn of foreign debt instruments last year, and the foreign sector taking $70bn of profits in European debt markets.
James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla
*CCLA is a supporter of Room151
