Sub-zero yields: Learning to swim

January 13, 2020

Today, every discussion about interest rates unleashes a multitude of grievances about how low they are. In reality, interest rates are not only low: they are, in essence, negative for those saving in euros.

Savers and investors have yet to adapt themselves to this context which is likely to dictate our day-to-day lives for the foreseeable future. With potential economic growth that is only partially explained by a lack of demographic growth, and rising public debt levels, central banks (particularly the European Central Bank (ECB)) will have to remain very accommodative.

Since the 1970s, the fundamental role of central banks was to limit the rise in inflation. Since the financial crisis of 2008, avoiding the spectre of deflation has also become a priority.

Despite the introduction of loose monetary policies and the large-scale purchasing of debt securities by central banks, inflation has proved to be elusive.

Initially conceived as a temporary policy, the ECB set its reference rate in negative territory in June 2014, intending to stimulate demand and revive productive investment. Despite this, as well as its mass bond-buying program, inflation remains nowhere to be seen.

Its absence has had a profound effect on the business model of banks.

To put it simply, the traditional activity of a bank is centred on monetary intermediation and transformation, with the collection of short-term deposits and the granting of longer-term loans. By acting as an intermediary between depositors and borrowers, banks earn interest on the difference between the interest they charge on loans and the interest they pay on deposits.

In periods of low interest rates, intermediation margins are reduced. In periods of negative interest rates, if these are not passed on to clients with deposits, margins drop into negative territory too. While plausible on a temporary basis, this situation quickly becomes destructive over the medium term.

In lowering the deposit rate from -0.4% to -0.5% in September 2019, the ECB also introduced a differentiated rate system. The new tiering system has clearly made the additional -0.1% move less painful for financial intermediaries. Consequently, the interest paid on the liquid assets placed with the ECB amounts to approximately 4.4 billion instead of 7 billion. A lesser evil at best.

All banks are striving to reduce liquidity but the ECB’s reinstatement of the quantitative easing policy in September 2019 has contributed significantly to the almost total erosion of the traditional currency transformation alternatives available to banks. Transforming maturities by reinvesting in longer-maturity bonds or transforming credit quality by reinvesting in corporate bonds has become almost impossible due to the dearth of opportunities and prudential constraints. The hunt for positive returns now resembles an Easter egg hunt the day after the children have found all the eggs.

Despite the implementation of a very accommodative monetary policy, inflation is still not on the cards. Should we criticise monetary policy and the key rate being set in negative territory? We believe it is pointless to try and rewrite history. On the other hand, it is crucial that the role of central banks be permitted to evolve, enabling them to fulfil their macro-prudential function.

The analogy between negative rates and the tale of Alice in Wonderland has become a classic. With negative rates, the time value of money is reversed. The situation is undoubtedly less poetic, but setting interest rates in negative territory suggests that central bankers are living in a topsy-turvy world. Financial repression, asphyxiation of the annuitant and so on – comparisons abound.

The unprecedented monetary experience of negative rates means that money is essentially a liability rather than an asset. With no end in sight for loose policy, one can imagine the Beatles song Strawberry Fields Forever playing in the background. It seems as though, in the words of the song, nothing is real!

Although scant consolation, it is nevertheless important to draw a distinction once again for our clients. As has been pointed out by a number of economists, the money illusion syndrome is not a new phenomenon. By giving up immediate consumption through savings, the objective is to benefit from improved future consumption. The history records show that real returns on savings (net of inflation) have been negative over multiple periods.

However, savers and investors should not procrastinate. Waiting for a possible rise in interest rates before taking action could result in a significant accumulation of opportunity costs. Denying reality is even worse. Refusing to see the truth is nothing short of senility. Reading up on the basics of quantum physics may induce a headache, but rejecting scientific progress has never led to anything good.

Maintaining a positive or zero return on conventional, liquid and risk-free savings costs financial intermediaries money. They cannot afford to subsidise the saver indefinitely to the detriment of their profitability and remain economically viable. But financial intermediaries won’t keep trying to swim upstream against the powerful current of central bank liquidity – they will adapt their product offerings. The future should see an influx of new alternatives to traditional savings that will help both banks and their clients stay afloat in this new landscape, but of course there will be no panacea.

Author: Group Investment Office