by Franck Dixmier, CIO, Fixed Income, Europe, Allianz Global Investors (via Project M Online)
When Mario Draghi set negative interest rates for money held at the European Central Bank (ECB) to -0.1% in June 2014, his action was not only unprecedented, it was as if he had taken us on a journey to Bizarro World. Giving up something today should always yield more tomorrow. Not so in the curious realm of Europe
For those who arenât familiar with Bizarro World, it is a creation of DC Comics in the early 1960s. Home to the super-villain Bizarro, the antithesis of Superman, it is a planet where everything is weirdly opposite of our expectations. In one episode, a salesman does a roaring business selling Bizarro bonds: "Guaranteed to lose money for youâ â which is not unlike the new world of European interest rates.
This era of Draghi runs contrary to thousands of years of accepted wisdom concerning the appropriate return from loaning out assets. The modern notion of âinterestâ stems from ancient cultures like the Sumerians where it described the act of renting out livestock in exchange for later receiving a larger herd in return. This idea is so ingrained in human culture that it is mentioned in the Code of Hammurabi, one of the oldest deciphered writings, which specified exactly how much interest could be charged on grain and silver.
Bizarro Interest
Recently, the yield for safe and liquid assets in the eurozone, such as German government bonds with maturities up to five years and longer, turned negative. This means the sum of interest payments over this period plus the return of the principal is less than the money originally loaned.
Until last year, this was inconceivable. While real interest rates â those received after inflation â often strayed into negative territory, negative nominal rates were thought impossible because investors could always keep money in bank accounts and at least earn a nominal rate of zero.
But the world of interest has been inverted. So why are people willing to lend money if they receive less back?
Speculation is one explanation. If yields drop, investors can still sell their bonds with a profit and this is exactly what some hope to do with the ECB initiating the quantitative easing program. Foreign speculators may also hope to gain by exchange rate movements which can counteract negative nominal yields. However, this is unlikely as the ECB's policy is weakening the euro, increasing the negative yield for foreign speculators.
The main answer as to why it remains attractive to buy-and-hold is because of Draghiâs 2014 decision concerning negative interest. Initially it was thought that this would only impact an arcane corner of monetary policy, the market for base money.
Base money is held by banks in their accounts at the central bank, but it is only one type of money that exists in modern economies. The money individuals keep in accounts at their bank, for example, is another part of the money supply known as âM1â by economists. Base money is distinct from M1 and only exchanged between banks, so it never leaves the electronic vault at the central bank except when transformed into cash in the form of physical notes and coins.
This cash is the only part of base money the public can get hold of. On June 5, 2014 the ECB took the decision to charge negative interest rates for money it keeps on behalf of banks. In other words, the central bank began charging banks for keeping their money. This action eliminated the role of base money in its electronic form as a store of value.
Bizarro Spillover
Why do banks keep money at the ECB if they could avoid the charge by switching to physical cash? First, besides once functioning as a store of value, base money acts as a medium of exchange. Banks use it to settle claims with each other electronically, so if a bank wants to meet obligations towards other banks on a timely basis, it needs money in an account at the central bank.
Second, the option of turning electronic base money into physical cash is constrained by the costs of receiving, storing and managing large cash piles. It is simply not practical to settle today's vast interbank transactions in cash.
Of course, banks are trying to minimize the impact of the negative interest rate. They are decreasing existing balances by lending to other banks. They are also buying assets deemed safe and liquid, such as highly rated government bonds that can be readily used as collateral in case of unexpected liquidity needs. These spillover effects are exactly what the ECB intended since they lower interest rates across the board in other capital markets, including for more risky government and corporate bonds and for retail debt.
The new paranormal
Those spillovers are good for borrowers, but bad news for investors and savers who are hurt by lower rates. As banks cannot be sure that the money stays with them for long and safe liquid assets with non-negative rates are in short supply, they are simply parking their money at the ECB and passing on the negative interest to institutional and corporate clients.
Given the interconnectedness of financial markets, it is hard to evade this charge by moving money into other currencies. When short-term funds moved into the Swiss Franc, the Danish Krone and Swedish Krona, the central banks in those countries also went Bizarro and introduced negative interest rates to fend off pressure on their exchange rate.
Some banks in Denmark, Germany and Switzerland are are passing the charges along to retail customers. However, close to zero nominal rates for other retail customers also makes a nonsense of the notion of âsavingâ in real terms.
There is little investors and savers can do if they are unwilling to take on other risks. The obvious solution for institutional investors, who are being effectively bled of money by banks, is to put their money into other assets. Unfortunately, this speeds up the process of lowering interest rates in these assets. To avoid negative interest rates, riskier and longer dated assets are being substituted for money and âmoney-nearâ assets like short-term government bonds. The end effect is to make cash management even more demanding for investors.
If this Bizarro World persists, it could see the emergence of new financial intermediaries dedicated to a more traditional model of interest. These entrepreneurs could ship large cash piles into derelict cold-war bunkers and issue interchangeable deposit receipts against them which then may become a currency on its own.
In Renaissance Italy, such a business model was the origin of a successful strand of financial intermediaries that later become known as banks. Then again, central banks in their supervisory role will look harshly at any way that emerges to escape their reach."
Originally published: Franck Dixmier (2015): Welcome to the Bizarro World of interest rates. 01.06.2015
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