31st May 2012
Today I wish to take a "Step Back In Time" as Kylie Minogue put it and revisit a subject I discussed back on the 2nd of September last year. This was the appearance of negative interest-rates and their possible spread from where they had appeared (Switzerland) to other countries too. This was the situation back then:
"UBS is now charging for some deposits and another Swiss bank is regularly submitting negative rates at the Swiss libor fixing. This trend is spreading further down the maturity spectrum as this week Swiss 3 month treasury bills were sold at a negative interest rate of 0.75% and last week 6 month bills were sold at a negative interest rate of 1%. Some bonds with longer maturities have briefly dipped in negative territory too."
Why was Switzerland the pathfinder for this?
There are several factors here which combined to make the Swiss Franc incredibly attractive as a currency to investors. Firstly if we go back to the middle of the last decade something called the "Carry Trade" took place where investors sold the Swiss Franc (by borrowing in it to take advantage of her relatively low interest-rates). As the credit crunch hit and uncertainty rose many of these trades were unwound leading to a strong rally in the Swiss Franc. Then came the problems in the periphery of the Euro zone which made nearby safe Switzerland look a haven and so yet more upward pressure was applied to the Swiss Franc.
The upward pressure is still continuing and after a long series of failed interventions the Swiss National Bank declared a currency cap of 1.20 versus the Euro. The pressure is still there as this morning the Vice-President of the SNB has again declared that it will intervene in "unlimited quantities".
What is the situation now?
If we look at the pressure to buy the Swiss Franc we can see that it is a capital issue for some and a fear issue for others. They are not looking for any particular interest rate and the demand has driven Swiss rates even further negative. I follow her two-year government bond yield as a measure and it has fallen to -0.12% and negative interest-rates have spread out to the four-year maturity.
What about real interest-rates?
Real interest-rates are calculated in theory by subtracting the rate of inflation from the interest-rate to give a measure of purchasing power. In practice this is not so easy as we need a forecast of inflation if for example we are looking at a ten-year bond yield.
However if we return to Switzerland we get a more confused picture as Switzerland has had a short period of a Japanese like situation as prices have fallen and they have fallen by 1% over the past year. If you look forwards as a holder of a ten-year bond yielding 0.59% has to do there is very little margin for any inflation! But we find ourselves in a bi-polar world and yet again it is created by a central bank.
If the SNB's hyperbole about "unlimited intervention" falls then we will see the Swiss Franc shoot up and her inflation is likely to be negative. If it succeeds then a rising money supply from intervention could easily lead to the type of inflationary pressure that last time Switzerland was in this sort of position saw her inflation rate rise to 7-8%.
If you think about it foreign investors in Swiss ten-year bonds are presumably betting that the SNB will fail and frankly this does look the most likely outcome.
But we are left with a troubling thought that over anything other than the short-term we do not have any reliable idea of what Switzerland's real interest-rate is. Again we see a tenet of economic theory potentially failing.
Is Switzerland as safe as many assume?
If we look at a country with a very large banking sector compared to its economic size we would conclude that it is a risk in a credit crunch era. And yet it is perceived as a safe-haven.
What about Germany?
The Federal Republic of Germany is right on the cusp of negative yields. There was a debate about a new zero-coupon 2 year bond (Schatz) issued last week in the media but at that point there was a yield of 0.06%. However yesterday after the circus had moved on German 2 year yields touched zero and are now 0.02%. So we can reasonable expect that the next Euro area panic will drive yields here into negative territory.
If we look further out we see that the German ten-year yield has dropped to 1.29% in a seemingly relentless trend. As analysis often involves those losing money let us consider a situation where holders of German bonds (bunds) have made considerable profits in recent times. Regular readers will be aware that I feel it is important to look at both sides of the ledger and the other side of screaming "Euro losses" headlines is profits for investors in German bonds.
And the real German interest-rate or yield?
German inflation averaged 2.3% in 2011 and is now 2.1%. So if we subtract around 2% from the nominal yields above we see that in shorter-term bonds investors are willing to accept negative real yields of 2% plus. Projecting such a trajectory forwards will be troubling for those buying ten-year bonds at a yield of 1.29%! Although of course we have little idea of what the later years will be like.
If you look at it the other way by wondering how far out German yields pass her inflation rate you are left with the disturbing realisation that they do not.
What about the UK?
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