Morning Commentary: Negative x Negative = Positive or Negative?

Foreign Exchange - Morning Commentary
Negative x Negative = Positive or Negative?
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Andrew Kositkun
Andrew Kositkun
Foreign Exchange Head Trader
Global central banks have dug deep into their toolbox in order to battle COVID-19 related headwinds.  With policy options limited, markets have increasingly been asking whether or not the Fed and other central banks with near zero policy rates will cut rates into negative territory.  With that in mind, let’s take a look at some common questions around negative rates.

Why are long term rates negative?

Policy rates are on the short end of the curve and are negative because that is where the central bank sets it.  Conversely, long term rates are composed of three parts: 1) the average of expected path of policy rates, 2) term premium which measures the risk around the expected path and inflation and 3) default risk premium. 

In Germany, the 10 year yield is negative because the ECB has set its policy rate negative and has committed to keeping it there.  This lowers the expected path and risk around the expected path.  Inflation expectations have collapsed and markets do not see default risk on German government debt.  All of this has led to negative long term yields. 

Why would an investor buy negative yielding debt?

Negative yielding assets are priced above par and pays out par at maturity.  This guarantees a negative yield if it is held to maturity.  However, if yields fall further between issuance and maturity, the value of the bond could rise (and be sold for a profit) before eventually converging to par. 

There is also the issue of alternatives.  For the most part, banks have not passed on negative rates to retail clients but large deposits are subject to negative yields.  In some cases, these negative rates are less attractive than negative yielding assets. 

What have we learned in Europe and Japan?

Both the ECB and the BoJ have negative rates and while negative rates have helped ease monetary conditions, there have been side effects.  In Europe, there is concern about the “reversal rate” or the level of rates where monetary policy becomes contractionary rather than accommodative.  In Japan, negative rates have flattened the curve and reduced banks’ ability to make a spread.  This is a bigger issue in Japan as Japanese banks are more dependent on deposits as a source of funding. 

Will the US adopt negative rates?
Fed official have clearly pushed back on negative rates, especially in the near term.  However, markets continue to price in a negative policy rate.  This appears to be a case of the markets extrapolating the Fed’s willingness to do “whatever it takes” and its use of “emergency powers” to support the markets a little too far.  Stronger forward guidance and yield curve control are more likely options should the Fed want to stimulate further. 

It is worth noting that a St. Louis Fed paper showed that negative rates and aggressive fiscal stimulus could help achieve a quicker recovery.  Given this, it would still take a broad shift in the Fed’s view before negative rates becomes a realistic possibility.  
  • The number of new infections in China continues to rise as officials added hundreds of flight cancelations to yesterday’s school closures.  In Sweden, the country’s state epidemiologist admitted that the country has made less progress towards herd immunity than expected. 
  • Geopolitical tensions remain high across at least three fronts: the Korean Peninsula, China-India and US-Germany.  On the Korean Peninsula, tensions rose when North Korea blew up an inter-Korean liaison office.  The China-India tensions resulted from a clash between the two countries along the Himalayan border, and US-German tensions are due to the US administration saying it would remove thousands of troops from Germany.  Overall, all of the countries involved have other issues such as COVID infections and economic headwinds going on.  While these issues warrant monitoring, there likely isn’t much room for further escalation. 
  • Fed Chair Powell will deliver the second part of his Congressional testimony today.  Yesterday, he appeared before the Senate and today he will go before the House.  In Powell’s Senate testimony, he gave a cautious outlook that should be repeated again today.
  • News reports indicate that Europe’s 750 billion euro recovery plan will be agreed to next month.  While there remains some resistance from certain countries (frugal four) to certain elements (grants instead of loans), the differences don’t appear to be insurmountable.  The shock from the pandemic also gives political cover for countries to change positions as is the case with Germany’s pivot of fiscal transfers.
  • Tiff Macklem, the new BoC Governor, spoke to the House of Commons Standing Committee on Finance.  While he did not stick as rigidly to ex- Governor Poloz’s assertion that the economy was following the “better case,” Macklem pretty much stayed on theme.
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