I am ambivalent about negative rates

Discussion in 'Fundamental Analysis' started by FXStreet_Team, Apr 11, 2016.

  1. FXStreet_Team

    FXStreet_Team Well-Known Member Trader

    Oct 7, 2015
    Likes Received:
    Over the weekend, I got a text from a friend of mine in the U.K. who was essentially asking my opinion about Central Bank's policy on negative rates, "Allo! Hoping to pick your brain a bit. What are your views on negative Euro interest rates and how long might they go on for?"

    While I first replied and said that I had to be honest, I was no expert on the hazy facets of the monetary policy transmission mechanisms that are unprecedented in nature being used by Central Banks currently, I would happily put my mind to it and respond. Presumably, one might be thinking to take out a loan in euros in exchange for a U.K. mortgage, denominated in sterling - Then that brings us to where I'm slightly more versed to advise upon when we are talking about FX risk and hedging given my corporate FX risk and industry background.

    But, let us now look at this mechanism that has been taken on by the Central Banks of late. The main motivation for these decisions is to further ease the already accommodative monetary policy stance to fight the growing threat of deflation amid downward pressures to inflation expectations, essentially designed to force the banks to start lending, by making it costly for banks to hold excess reserves at their central banks and to encourage consumer spending, which is essentially oiling the cogs in order to get the whole financial system fluid again.

    Phenomenons of negative rates

    If you want to get technical about these things, which I rarely don't, given I am only really focused on the bigger picture and what the implications are that might lie ahead for the FX space, amid negative policy rates, you might wish to look into the bond market because nominal yields on some bonds of highly-rated European governments have also dropped below zero and perhaps the main proximate cause to that are the increased scarcity of highly-rated sovereign bonds eligible for the European Central Bank's asset purchase program. Other phenomenons of negative rates include very low inflation and a “flight to safety” toward fixed income assets in Europe's core. However, as said, the effect of negative rates on the FX space is what I am really interested to understand.

    Negative rates might help boost exports by encouraging currency depreciation and that in turn could then encourage more lending and domestic demand in the longer-term, which is surely the objective of the Central Banks as this will bring them along towards their inflation target for their economies and in theory, making for nice two way business for the FX trader over the long-term.

    Adverse consequences of negative rates

    However, at the same time, there could also be some adverse consequences for financial stability and that is also what makes a market in FX. For instance, downside risks to an economy taking on negative rates could come through an erosion of bank profitability who are being charged on their deposits and it will take some calculating to understand the break even points as it may cost more to lend out the money in the first place, if rates are not negative enough, while retail banks may choose to internalize the costs associated with negative interest rates by paying them, which will negatively impact profits rather than passing them on to customers for fear of losing their business, i.e. deposits. Also, the more complex or abstract we get about it, you have to take in the possibility of excessive risk-taking by investors who are seeking a higher rate of return and the complications that come of that as well as the potential implications for developing countries that also include a search for yield supporting capital inflows, which could help offset the impact of the liftoff in U.S. policy interest rates, for example.

    So as you can see, while I have put some time into this over the weekend for just my friends initial query, it is indeed quite an ambivalent subject when asked for your opinion on the matter and how long negative rates will last. I don't even think those who implement the measures have much of a clue either. To me, it seems to be the last resort a Central Bank will take in the most desperate of measures to try and stabalise a derailed economy that could otherwise be headed for a very hard landing.

    It was way back on 4th July 2013 that the Governing Council of the ECB communicated that it expects the key ECB interest rates to remain at present or lower levels for an "extended period of time". It was then in June 2014, the ECB pushed the policy interest rate applied on its deposit facility below zero for the first time, with an additional cut in September 2014. Then, this year, the ECB cut rates again on March 10th, charging banks 0.4 percent to hold their cash overnight. At the same time, it offered a premium to banks that borrow in order to extend more loans. so we are not getting any closr to the end by the looks of things 3 years later. The Governing Council of the ECB will meet again on 21/04/2016 monetary in Frankfurt, so we will watch closely to that outcome as well.

    They are all at it

    But, the ECB are not the only Central Bank to go down this road. The Bank of Japan also surprised markets by adopting negative interest rates in January this year. Janet Yellen, the U.S. Federal Reserve chair, first said in November 2015 that a change in economic circumstances could put negative rates “on the table” in the U.S. She said again this year that while it is not something that is being considered currently, it is not out of the question. Meanwhile, there were other Central Banks that also went negative, but for other motivations, such as the the SNB and DNB.

    Full blown currency wars on the horizon

    If it gets to the point that more and more central banks start to use negative rates as a stimulus tool, then that brings in the risks of an outright currency war of competitive devaluations. Indeed, we are in unprecedented times and it is all too hazy for anyone to be able to forecast a precise outcome. Even the Bank for International Settlements warned in a March 2016 report of “great uncertainty” if rates stay negative for a prolonged period.
    For more information, read our latest forex news.

Share This Page

free forex signals