The race to the bottom amongst central banks has not stopped at zero and has extended into negative interest rate policy. Currently, the Bank of Japan and the European Central Bank employ a policy that includes negative interest rates.
Both policies have pushed long term interest rates down sharp enough to generate negative rates as far out as 10-years. This means that is you purchase a Japanese sovereign government bond, with a 10-year tenor, you will lose money at maturity.
So what are negative rates and why would a central bank employ this strategy? First a little about central banks…
The Function of Central Banks
In general, a central bank is a bank of a country or union (such as the European Monetary Union). Institutional commercial banking companies have accounts at the central bank just like you would have an account at your local bank.
These central bank accounts allow it to handle its daily business. By making policy tighter, the central bank restricts the business of a money center bank and when policy is looser, business can flourish.
A Negative Interest Rate Explained
A negative interest rate is similar to a regular interest rate but instead of the borrower paying the lender, the lender pays the borrower.
With a regular rate the central bank would pay a commercial bank interest on its deposits, with a negative rate, the commercial bank has to pay the central bank an interest rate to keep money on deposit at the central bank. Central banks lend and borrow to commercial banks all the time and their overnight rates set a floor and ceiling for borrowing and lending.
So rates in a few developed countries are now negative. In Japan, the deposit rate, which is the lower rate is negative. This means that instead of receiving interest on deposits commercial banks in Japan now have to pay for depositing funds at the Bank of Japan.
Now, just because the deposit rate in Japan is negative does not mean all interest rates in Japan are negative. While nearly all sovereign bonds are in negative territory, such as the Japanese government bond, corporate bonds, municipal bonds, and high yields bonds have positive interest rates.
The interest rate used by the European Central Bank for refinancing is zero. This is the rate paid by banks when they borrow from the ECB for longer than overnight. So why would someone want to pay the government money to hold on to capital for 10-years?
The answer is safety.
Government bonds at G3 countries, such as the United States, Europe and Japan are considered risk free, meaning there is little chance if any that you will lose your money because the sovereign nation defaults. Since there is a lack of options for pension funds that need to hold on to risk free instruments, the 10-year bond is in some cases a necessity.
Is Purchasing a Bond with a Negative Rate Crazy?
In a way, pledging your money to a country where you need to pay them to hold on to your money for 10-years, is crazy, and that is exactly how these central banks want you to feel. They want you to take more risk and place your money in assets that will increase in value, so you will feel wealthier and potential spend some more money.
The central bank removes a portion of a commercial banks capital every day when the interest rate is negative. In theory, a commercial bank would reduce its reserves considerably when there are negative rates in an effort to reduce their costs.
Generally, the central bank only charges on reserve balances over a specific amount. Commercial banks cannot use their excess reserves to lend money to consumer, they only can use this excess capital to lend to other institutions.
The central banks created excess reserve to protect against adverse market scenarios. Prior to the financial crisis in 2008, commercial banks rarely had excess reserve, but in a world were some banks are too big to fail, this process is now deemed necessary.
For times when market volatility is beyond what is considered normal, central banks have created extra reserves for emergency situations. For situations like the European Debt Crisis, banks were afraid to lend to one another the central bank needed the excess reserve to keep commercial banks solvent.
Negative Rates Generate Price Appreciation
Does a negative deposit rate help generate price appreciation? Sure, if a commercial bank is being punished for keeping excess reserve on hand, they are more likely to lend that money to another commercial bank, helping to stimulate growth and inflation.
In essence this pushes the lending rate down. As banks start to attempt to lend their excess reserves to other commercial banks, they run into competition which further reduces the rate.
The decline in the overnight rate drags down other rates making it cheap for consumers to borrow. When consumers borrow at lower rates they tend to invest and spend more money.
Negative interest rate also incentivizes banks and investors to purchase items that are like capital such as short term debt and other safe government instruments. Rates for financing in the capital markets will also decline along with the decline in the deposit rate.
So how does a negative rate effect a currency?
Well, when you purchase a currency pair you receive the interest rate of the currency you are long and pay away the interest rate of the currency you are short. This is referred to as the yield differential.
If you are long a currency that has a negative rate and short a currency that has a positive rate, you will be paying away on both sides of your trade. The negative rate currency becomes unattractive which is also a goal of a central bank.
Negative rates in theory make a currency less attractive and therefore should decline in value. So if you are long the CAD versus the USD you would be paying away to hold that position.
The introduction of negative interest rates is relatively new, and both the ECB and BoJ are not sure how this experiment will play out. Both Japan and the Eurozone are facing low inflation and so far, this technique has not been able to increase inflation to the target range of 2%.
This is a guest post by Irit Rutenberg at FX Empire. All opinions expressed are those of FX Empire and not of Trading Heroes.