Positively negative

ab
1 February 2016
Asset management
Positively negative
Economist Insights
Joshua McCallum
Head of Fixed Income Economics
UBS Asset Management
[email protected]
In an apparent volte face, the Bank of Japan introduced
negative interest rates, much to the surprise of the markets.
By targeting only marginal transactions, the BOJ is more
similar to the approach taken in Switzerland, Sweden and
Denmark than by the ECB. The market reaction was much
stronger than the reaction to the ECB's introduction of
negative rates. It was also more widespread, suggesting
that markets might be now expecting a dovish reaction by
the ECB and the Federal reserve.
Never trust a central banker, at least not one that you
would actually entrust with control of monetary policy. Just
a couple of months after ruling out a further cut in interest
rates, Bank of Japan (BOJ) governor Kuroda Haruhiko
announced negative interest rates. Governor Kuroda does
seem to enjoy surprising the market, and some wonder
whether he misled the market on purpose in order to
maximise the surprise.
It is more likely that Governor Kuroda simply changed his
mind and decided that the economic situation demanded
more action. That is why you should not trust a good
central banker: they should do what is best for monetary
policy, not what keeps the market happy.
The Japanese negative rate is somewhat more complicated
than that of the ECB, and is closer to those of Switzerland,
Sweden and Denmark. The negative rate applies only to
marginal increases in cash rather than all cash. Existing levels
still get paid 0.1%, required reserves (and a few other things)
get 0% but the remainder will get -0.1%. The equivalent
from a personal perspective is that your bank pays you
interest on most of your deposits, but pays zero on some.
Then any increase in deposits you make would be penalised
with a negative rate. This might change the amount you
decide to deposit. You could hold more cash, but that brings
risk of loss or theft. So the alternative is to spend more.
The difference for the banking system is that they cannot
really control the level of their reserves at the central bank.
When the BOJ creates money through their Quantitative and
Qualitative Easing programme (QQE), they credit the reserve
accounts of the banks they do the transactions through.
That bank can then take the money out and use it for
something else (e.g., a loan), but that money will ultimately
Gianluca Moretti
Fixed Income Economist
UBS Asset Management
[email protected]
end up in another bank. Asides from cash, all digital money
is a claim against the central bank. So the BOJ is increasing
the amount of money in the system and charging banks for
the privilege of having it on their balance sheets.
The marginal rate at least prevents the banks from being
'taxed' on their existing levels of deposits. The BOJ does
not want to damage the banks that much, since it might
make them less able to lend. But there will likely still be a
hit to profits. The BOJ has kept discretion on how much of
bank's reserves they want to charge the negative rate. If
they choose to maximise the amount, the weighted average
interest rate paid on reserves would be falling quite quickly,
going through zero in 2019 (chart 1). If instead the BOJ
limits the marginal amount that is charged the negative rate,
for example to 25% of last year's total reserves, then the
average rate will stay positive for the foreseeable future.
Chart 1: Waiting for weighting
Weighted average interest paid on reserves at the Bank of Japan
(simulated, basis points)
10
8
6
4
2
0
-2
Jan-15
Oct-15
Historical
Jul-16
Apr-17
Lowest rate
Jan-18
Oct-18
Jul-19
Apr-20
With cap of 25%
Source: Bank of Japan, UBS Asset Management. Note: assumes that the ratio of
required reserves to total reserves stays constant
The market reaction illustrates that interest rates are,
indeed, determined by the marginal transaction. So even
though the weighted average interest rate is likely to
remain positive for a long time, the yield curve dropped
into negative territory all the way out to the 9-year bond
(chart 2). The benchmark 10-year bond reached an all-time
low of just 5.5 basis points. This is a very different reaction
to what the ECB experienced when it introduced negative
rates on all deposits (not just marginal deposits). The
German bund yield curve actually steepened with yields
at the front end falling less than Japan just saw, and the
longer end actually rising.
Chart 2: Dipping below
Japanese sovereign yield curve, %
1.4
1.2
It is not just Japan that reacted to the move, other markets
moved as well. Both German bunds and US Treasuries fell
by almost as much as Japanese bonds. This has less to
do with the importance of the Japanese market and far
more to do with the likely reactions of the ECB and the
Federal Reserve. The ECB will be noting how effective the
BOJ move was at shifting yields, which may make them
interested in copying the strategy. Even though countries
like Switzerland are already using very negative rates with
complicated tier structures, the BOJ has demonstrated that
a large economy can do it successfully as well.
For the Federal Reserve, which has seen the strong
exchange rate drag on US growth, this move by Japan
creates just one more reason to delay rate hikes. The
market now feels that a March hike looks highly unlikely.
Lots of investors are talking about 'currency wars', and
indeed the currency seems to be the main channel that the
BOJ is hoping will boost the economy.
1.0
0.8
0.6
0.4
0.2
0.0
-0.2
-0.4
demand a higher price for the bond today, which means
a lower yield. Or to put it another way, the banks have to
discount the future cash flow of the bonds at a negative
rate (so should that be an 'up-count'?).
0
1st Feb
10
28-Jan
20
30
40
Years to maturity
Source: Bloomberg Finance LP
There are two good reasons why the experience was so
different. Firstly, unlike the ECB, the BOJ's programme of
quantitative easing is open-ended. Not only does this mean
that there will ultimately be more reserves on which the
negative rate might be paid, but it also signals that the BOJ
is keen to use every tool at its disposal. This could explain
the divergence in reactions at the long end.
So it looks like negative rates are here to stay, and likely
to become more common (at least in this complicated
form). Now it is just a matter of waiting to see what the
unforeseen circumstances might be. For example, banks
may be unwilling to pass negative rate on to depositors,
but they need to make up their profits somewhere. There
is some evidence from Denmark that negative rates have
actually encouraged banks to increase mortgage rates. This
is the opposite of what the central banks want to see. But
if you invert interest rates, you should not be surprised to
see lots of other relationships invert as well.
The second reason is somewhat more technical. The
negative deposit rate can be seen as a tax on any future
financial assets that banks sell to the BOJ through the QE
programme. Why is it a tax? Because when the BOJ buys
the bond it will pay for it by creating reserves that pay the
negative rate. So from the banks' perspective there is a tax.
Banks therefore need to take that into account and will
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