Negative Interest Rates: The New Central Bank Playbook
Where They've Worked, Where They Haven't & What's Next?
Central Banks have followed the routes of smaller emerging market central banks by moving into negative interest rate territory.
What Negative Rates Mean?
There is shock and awe associated with negative interest rate, but it's important to know what it means to you and the broader economy. Negative interest rates do not mean that when you go to place another chunk of your income in savings account that you will have to pay the bank the honor of holding your money.
Instead, negative interest rates mean that excess money that your bank and others hold with their central bank will be charged a fee of the negative interest rate.
Right now, Sweden's Riksbank has the most aggressive interest rate policy of G10 currency, with -4.5% while the European Central Bank and Bank of Japan have interest rates closer to zero, but still negative. The intentions of such an act, as good as they may seem, is to create an incentive for banks to lend an increase money flow in their economy.
How the Sectors are feeling the pinch
So who is being negatively affected by such actions? The obvious initial answer is banks who make money by earning money by receiving the spread of interest received to loans made and interest paid from borrowing money from central banks. They have a new expense on the balance sheet at a time when revenue is already low because of the lack of activity this intervention trying to stimulate.
However, there are signs of the negative effects this is having at the start. In Japan, the Topix index of lenders has slumped 18 percent since the Bank of Japan introduced interest rates below zero on some reserves on Jan. 29. It shows us that shareholders are no longer interested in the upside of banks who are being forced to pay interest on excess capital they hold from depositors.
It is unsure how other sectors will fare long-term, but shorter-term there is hope that the consumer surplus of paying less on debt interest will help spur the economy.
Watch for the Carry Trade of 2016
The Carry Trade is a natural occurrence in markets of competing for borrowing rates. However, never before have those who prefer a carry trade had the benefit of a negative yielding funding currency. In other words, Carry Trade FX traders are getting compensated on both legs of the trade.
The catch, in no uncertain terms, is that the reason we're in a negative interest rate environment is because things appear very near to the point of falling apart in a similar, albeit the presumably less intense version of 2008. Should this happen, no Carry Trade player would be safe as the unwind of the Carry Trade is one of the most severe and quick phenomena in retail FX.
Many experienced traders have looked back on 2008 as a large unwind of the carry trade that had built up in years prior. However, until then, traders could do worse than finding the high-yielding emerging markets like Peru, Turkey, or India (my preference) to employ a Carry Trade strategy.
The main premise of negative interest rates is to spur activity from the banks and therefore, the larger economy.
Such a pickup in borrowing and growth ideally raise inflation, which central bankers have been completely unable to hit their targets of 2%. However, there is an appropriate fear that the world is awash with debt, and much like the overeager diner at an all-you-can-eat buffet which had one extra plate too many, there simply is not any more room for growth fueled by borrowing.
Such an outcome would favor a larger scale deleveraging that is often painful and unpredictable. Deleveraging comes with bad projects being purged, bad loans or nonperforming loans being written off, alongside a run into haven assets like gold, yen, and the recent carry trade unwind currency the euro.
As noted above, the environment seems ripe for a favorable carry trade world. You have some currencies with relatively high-interest rates like South Africa and other currencies with negative interest rates like Japan and Europe.
However, this is an area where the textbook does us less good than an understanding of psychology in the markets. If fear continues that we are heading for deleveraging, we could continue to see volatility increase and money continue to flood into negative interest rate currencies as they unwind trades in the past that continue to underperform and whose medium-term outlook remains unfavorable.
Markets often seem simple when looking at their history and seeing how the stories play on the market price, however standing on the right side of the chart and looking into the future there is mass confusion, and 2016 offers one of the most confusing years ahead since 2008. Obviously, we hope it does not turn out the same way, but at the same time, it would be foolish not to be on the lookout for such a run into haven assets.