Several of the major Swiss banks recently followed their Danish counterparts and began imposing negative interest rates on deposits, charging customers for the privilege of keeping cash in Swiss francs.
The move, like Denmark’s last year, was an attempt to stop the appreciation of the franc against its major trading partners by discouraging inflows into the currency. Negative rates come on top of the existing peg, set at 1.20 by the Swiss National Bank (SNB) between the franc and euro, which the central bank has defended stoically since September 2011 by buying vast amounts of euros in international markets.
With interest rates at record lows across most of the developed world, central banks are continuing to push ahead with unconventional policy measures to try to kick start sluggish growth.
Quantitative easing (QE), central banks’ weapon of choice to inject money into the economy since the crisis began, was initially very effective in averting the worst of the slowdown. But now this practise seems to be suffering from diminishing returns as the market perception evolves from one of awe to indifference with each new round.
Negative rates are one route authorities could take, should they deem foreign demand is now the best way to achieve higher growth, via a lower exchange rate or attempt to stop appreciation of the currency choking off domestic industry.
Savers punished
From a cash management perspective, low interest rates already pose a problem. Those holding excess cash either for margin strategies or simply waiting for the right moment to invest in other asset classes are punished for doing so by little or no return.
Negative rates actually erode the value of cash in the bank – by charging to deposit – making effective management of cash even more important. Short-dated government bonds have cash- like features, should earn a return in excess of cash in normal markets and are used extensively to put excess cash to work.
However, in the current environment safe-assets or the perceived lack of them is a dominant theme, and the very safest are commanding a huge premium.
Short-dated German debt, for example, is currently yielding a negative nominal interest rate, meaning you are in effect paying to lend to the German government. The closure of some money market funds to new money unfortunately seals off another route usually open to cash managers to park excess funds and earn a return.
Currency, specifically if a central bank retains the ability to issue it, plays a large role in deciding which debt is deemed the safest. The European sovereign debt crisis has many causes, but one of the reasons it became so alarming last year was because the European Central Bank (ECB) initially refused to create money to buy Spanish and Italian debt. This meant eurozone governments were held hostage to the market.
The UK, on the other hand, has historically low yields on government debt, in part because the Bank of England (BoE) remains the buyer of last resort for UK gilts.
Adviser’s dilemma
Wealth managers face a tough choice in the current environment. They can either chase yield but take on increased risk, or park cash in perceived safe assets and incur a levy for doing so.
Bring in active currency management by central banks and you add a third and potentially very disruptive element into any decision. Negative interest rates would make the situation harder still, but holding physical cash in note form – stuffing cash under the mattress – is increasingly attractive since negative rates would only apply to electronic money.
Derivative markets offer some hope, providing the ability to lift yield. Swapping dollars for euros, for example, currently offers enough of a return to compensate for the lower yielding German bonds compared to US treasuries and is a reason the euro remains well-bid in today’s market.
Areas of the wholesale financing markets, such as secured lending via repo (repurchase agreement), remain one of the few areas in the current climate where those with the know-how can make potentially attractive returns.
Moving away from fiat currencies altogether, gold could be used as an effective cash management tool in a negative interest rate environment. It is a large liquid market and although having a zero yield, gold like physical cash, would be unaffected.
Gold could also protect from those unconventional central bank policies having unforeseen negative consequences. The downside to gold, however, is its volatility and current high price.
Hedge your bets
Negative rates are uncharted territory for retail banks. There are very few products in the market that currently provide security and attractive returns in the existing low rate environment, let alone one where nominal rates are negative.
If security remains preferable over higher returns, it is possible there will be more government-insured accounts launched like the Federal Deposit Insurance Corporation (FDIC) in America, which temporarily allowed unlimited coverage for non-interest bearing accounts after the financial crisis.
However, that coverage came to an end on 31 December 2012 and there is a large amount of money now currently looking for something similar. The Federal Reserve has speculated on what retail products might look like if negative rates were to appear and they range from a bank holding physical cash in a vault to a prepayment credit card.
In terms of currency, one thing to avoid at all costs is taking unhedged currency risk, especially as we move towards an environment of active currency management by central banks.
Moving money from currency to currency chasing yield is understandable, albeit risky, but hedging via the forward or option market is vital. Unless you have existing exposure to currencies where central banks are openly looking to devalue, like the Japanese yen, it may be best to advise clients to avoid them altogether.
Alistair Cotton is senior analyst at Currencies Direct
