Recent trends in the RMB

This year the RMB has bucked its recent trend and remained broadly stable against the US dollar for the first half of 2017. As the Trump reflation trade has unwound to some degree, and the dollar retraced, the RMB has seen some depreciation against its main trade partners. For policymakers in China this is a convenient outcome, though there exists a delicate balance to maintain. Too fast a depreciation risks discrediting recent emphasis on ‘relative stability’ and the recent change to the PBoC’s fixing mechanism looks to be a reflection of this need.

Key RMB movements so far in 2017

Up until the end of May, the CNY traded in a narrow range against the US dollar, though at the beginning of March a gap opened up between the trade-weighted US dollar and the direct bilateral USDCNY exchange rate (figure 1). While sentiment on China this year has improved on a relative basis, market participants still worry about a number of issues including softer growth, financial instability, and the impact of deleveraging, which has encouraged this disconnect. A flat USDCNY exchange rate in the face of a depreciating dollar more generally, has therefore led to a decline in the trade-weighted RMB index (figure 2).

A healthy easing

To policymakers, this is not a bad outcome. Firstly, a trade-weighted depreciation provides some much needed offsetting stimulus to counterbalance rising lending rates and efforts by officials to crack down on leverage in the economy, which will weigh on growth (figure 3). Secondly, China has battled both speculative and domestic outflows, and depleted around a quarter of its reserves in the process. A weak dollar but stable China/US bilateral exchange rate allows for a supportive depreciation, while helping to discourage capital outflows and replenish currency reserves (figure 4). Admittedly, it is difficult to tell whether the recent stabilisation in capital outflows is indeed down to improved domestic sentiment or more effective capital control measures.

The new fixing mechanism for CNY

While a trade-weighted depreciation is certainly convenient, PBoC officials will be keen to maintain perceptions of ‘relative stability’, whether that be against a currency basket, or against the US dollar (the emphasis appears to change depending on the dollar’s trend). In line with this objective, towards the end of May, the PBoC unexpectedly changed its USDCNY fixing mechanism, adding a counter-cyclical adjustment factor. Previously, the fix was determined by two components primarily; the prior day’s close in USDCNY and an adjustment factor which aims to keep the trade-weighted RMB stable.

The first component helps to explain why USDCNY and the DXY index recently diverged, and the new countercyclical adjustment factor aims to promote two-way flexibility but prevent these kinds of unwarranted divergences in the future. In the days running up to the fixing change, USDCNY fixings came in far below what previous market closes implied, and the recent change could partly be an ex-post rationalisation of these lower fixes. In effect, this new methodology gives the PBoC a greater degree of discretion over the fixing rate, should it judge USDCNY to be diverging from fundamentals.

Total returns tell an alternative story

The recent depreciation of the RMB index has been part of a longer-term adjustment to macro adjustment under which the RMB has depreciated on a trade-weighted basis by around 8.5% since the start of 2016. However, from the perspective of exposure to Chinese currency risk, it is essential to assess returns on a total returns basis which include the accrual interest rate differentials, rather than the spot performance independently.

While the CNY has depreciated by 4.7% and 5.0% against the US dollar and G4 currencies respectively since the start of January 2016, total returns for the same period were positive at around 1.4% and 2.3%, respectively. The RMB has therefore compensated holders on a total return basis via a higher nominal interest rate. According to prevailing forward currency curves, this interest rate differential is expected to persist into the future and if so, will continue to form an important component of return for the RMB.

Czech that out ! A story foretold in FX markets

  • We assess the implications of the removal of the CZK to EUR peg on April 6 2017 and what this means for how central banks manage peg removals going forward.

The CNB announced earlier today that they abandoned their commitment to the EURCZK floor at 27 CZK per EUR whilst also saying that they will only intervene to prevent “excessive” exchange rate moves. The initial reaction has been muted, with a modest CZK appreciation circa 1.4% against the EUR at the time of writing, but additional pressure from the re-establishment of short EURCZK positions might cause CZK to appreciate over the medium term especially seeing as CNB Governor Rusnok stated in this press conference that this was likely the beginning of a tightening cycle. Furthermore, from a fundamental macro point of view, Purchasing Power Parity (PPP) would suggest a stronger CZK vs almost all major currencies including EUR.

At this point, it is reasonable to ask how this compares to January 15 2015, when the Swiss National Bank undertook a similar task when confronted with the need to remove the EURCHF floor. While the initial conditions are different, i.e. CZK is a much less traded currency, and not at the neuralgic centre of the FX markets as the Franc, there are lessons to be learned even at this early stage in terms of how central banks remove pegs.

First, the Czech National Bank (CNB) must be congratulated in the way it managed to cause minimal disruption from the de-pegging, whether one looks at spot moves, implied volatility, liquidity air pockets below 27 and simply good old fashioned market sentiment, where participants seem to have taken this move in their stride. The key to why this was successful in avoiding market stress and further collateral damage was to do with the CNB’s extremely transparent and well telegraphed communication about the end of the peg arrangements. Market participants had been repeatedly told the conditions under which the peg might go, namely, inflation hitting the target of 2% and staying consistently above it, something that has been the case since late last year (see chart below). Since the beginning of 2017, CNB officials repeatedly told the market in no uncertain terms (for what is usually stale central bank speak) that there was a very real possibility that they might remove the peg at any point this year (the latest pronouncement being Governor Rusnok in the local media muting in March that the most likely timing of exit is still “the middle of 2017”.

This increasingly targeted, transparent and focused “forward guidance” (to borrow a phrase) begun to be significantly priced into EURCZK forwards as early as 2016, and pricing became even more acute in 2017, so that the “carry cost” of a long 1m EURCZK forward in March was about 3.5% (annualised) and 80bps (annualised) at the 12m horizon. In essence, CNB policy was extremely adept at dissuading long CZK speculators (with little natural CZK asset exposure) from taking large trading positions given that the opportunities for profit and loss were finely balanced should the peg break. Market equilibrium pricing resulted in what was beginning to look like a zero profit trade at inception, given the expectation of CZK appreciation once the peg was removed.

By pre-committing itself to the “time” dimension, the CNB managed to avoid a large market dislocation. This is something that the SNB refused to do, and, by keeping its options open in terms of when to remove the peg perhaps in avertedly ended up sacrificing the “volatility” dimension of the final outcome once the peg was removed. Not all pegs are created equal (the SNB’s task was arguably an order of magnitude more complicated given the need to recycle Switzerland’s large current account surpluses outside the CHF zone and the sizable headwinds this resulted in), yet the lessons to be learned will certainly serve future central bankers, perhaps in Croatia, or even Denmark and Hong Kong as well.

FX markets in the Trump era

  • Since the US presidential election on November 9th, markets have generally welcomed the more conciliatory tone from the President-elect Donald Trump.
  • How might the changing economic environment affect currency hedging decisions, and what does this mean for currency returns?

Since the US presidential election on November 9th, markets have welcomed the more conciliatory tone from the President-elect Donald Trump. Contrary to expectations, developed market equities have outperformed, while bond markets have sold off on the back of infrastructure-inspired growth expectations and a step up in nominal and real yields. The US dollar has been the beneficiary; since the election, the US dollar has gained against almost all developed market currencies (although, as British Prime Minister Theresa May sought to soothe businesses’ Brexit concerns, the dollar fell marginally against the pound sterling). The Japanese yen has been the worst hit as the Bank of Japan’s recent commitment to zero percent yields has amplified the impact of a US yield curve steepening.

Emerging market (EM) currencies have received no exemption from the dollar’s rally, though declines are not dissimilar to those witnessed in developed markets. Unsurprisingly, losses have been most pronounced in the Mexican peso, while other currencies also expected to suffer from protectionist policies, such as the Taiwanese dollar and Indonesian rupiah, have not fared as badly. The relatively muted reaction in other emerging market currencies is likely the result of healthy national balance sheets and co-ordinated central bank action; according to several measures, reserve adequacy had risen following the rout in 2014/15, and these reserves were utilized effectively to promote stability while the market adjusted to a new equilibrium.

 

spot-currency-performance-1 spot-currency-performance-2

How might this affect the decision to hedge?

The election of Donald Trump has had a profound impact on markets and may mark the beginning of a new economic era; one which emphasises fiscal policy, protectionism, and entrepreneurialism. The consequent evolution of correlations, volatility, and interest-rate differentials in the currency markets will affect the trade-offs involved with any hedging program.

We note that the US dollar has begun behaving in a more risk-on fashion of late (foreign currency and equities have moved inversely) while volatility is elevated and interest rates have repriced upwards quite significantly. The evolution of currency/equity correlations is the most uncertain factor. On one hand, the expected change of the US dollar from a low-yielding to high-yielding currency and the resultant reallocation of global risk capital could encourage pro-cyclical behaviour in USD. Additionally, economic theory[1] would suggest that a shift in policy focus away from monetary tools towards fiscal policy would increase medium-term correlation between risky assets and the US dollar. On the other hand, however, we expect US Treasuries and other USD assets to maintain their safe-haven status among investors, contributing to counter-cyclical behaviour in USD.

How do these factors affect the decision to hedge? We find that in aggregate a US dollar-based investor hedging Eurozone equities will benefit from the changing environment outlined above. Changing correlations could mean that currency hedging becomes less able to reduce portfolio volatility, but higher US interest rates would increase the excess return added by a hedging program, such that an investor’s risk-adjusted return is still boosted by currency hedging.

Using Eurozone equities as an example, in the charts below we evaluate for an optimal hedge ratio, both from the perspective of volatility and risk-adjusted return. The increase in future currency volatility implied by the option market suggests the need to hedge more, especially if the current correlation levels[2] (between Eurozone equities and EURUSD) persist at around -0.2 (left panel, light green line). However, this correlation has been on a strong downward trend since late-2014, which likely reflects changing attitudes to risk as interest rates in the US normalize. If falling equity/currency correlations intensify, portfolio volatility would be reduced by hedging less than 100%, then from a volatility perspective the optimal point at which to hedge will be lower (left panel, dark green line). However, the changing interest rate environment (sustained low rates in the Eurozone and Japan and elsewhere, with expected increases in the US) also has an effect on risk-adjusted return.

In the ‘new normal’ era of lower returns, we find that any additional returns over and above the equity risk premium have a larger impact on risk-adjusted return. For a US dollar-based investor, this means that the higher future interest rate differential (implied by interest rate swaps), earned via hedging back to the US dollar helps to offset the increased volatility at higher hedge ratios. In the second chart below we show that the risk-adjusted return increases with more hedging. Therefore, considering portfolio volatility and risk-adjusted return in combination, a 50% hedge ratio would be a sensible choice under this regime change, and could increase risk-adjusted return relative to being unhedged by up to 25%[3].

 

volatility-and-ir-smile

Market volatility presents opportunities in currency

The election of Trump and the higher potential of both anticipated extreme events (e.g. Brexit, other European elections) and unknown extreme events (e.g., the Swiss floor) will present interesting opportunities within currency. Positioning a currency portfolio towards various FX risk premia enables an investor to undertake specific and well understood risks, and to exploit inefficiencies within the market. Many of these risk premia extend across asset classes, including carry, momentum, value, and structural opportunities in emerging markets.

The most important takeaway from the election is that the political shake-up underway implies more extreme policy moves and a greater degree of cross-country economic dispersion. We believe this helps to expand the opportunity set within currency in a number of ways. As real interest rate distributions become wider, carry returns will tend to increase; moreover, the trends in real interest rates are a major explanatory factor in medium-term currency moves which momentum strategies can exploit. This, in turn, can lead to dislocations from fair value, which provide favourable conditions for value strategies.

In emerging market currencies, further rises in US interest rates following Trump’s election could come as a headwind to short-term performance if investors redeploy capital based on relative yield opportunities, and if EM corporates begin to re-examine hard currency borrowing decisions. That said, the medium to long-run drivers of EM currency returns – productivity growth and real interest rate differentials – are expected to remain positive relative to the US and other core developed market currencies. Short-term drawdowns therefore present more favourable entry points for investment in emerging markets, while investing against a diversified basket of short developed market currencies can insulate against country-specific shocks and enhance return.

 

[1] In the Mundell Fleming economic model fiscal expansion under a flexible exchange rate regime leads to currency appreciation.

[2] Correlation is measured on a 36-month basis between hedged Eurozone equity returns and long euro short US dollar currency returns.

[3] Calculated analytically based on the given assumptions and the formula for variance of a portfolio consisting of two components (A=FX; B= asset; W = 100%)

Assumed volatilities based on 1-year current and forward option implied volatility. Assumed interest rates based on 1-year current and forward swap rates. Assumed local EMU equity return based on EUR risk free rate plus 3.5% expected equity risk premium.

 

 


Record is authorised and regulated by the Financial Conduct Authority in the UK, registered as an Investment Adviser with the Securities and Exchange Commission in the US and registered as a Commodity Trading Adviser (swaps only) with the US Commodity Futures Trading Commission, is an Exempt International Adviser with the Ontario and Alberta Securities Commissions in Canada, is registered as exempt with the Australian Securities & Investment Commission.

This material has been published for professional investors & consultants. All data, unless otherwise stated in the footnote of the relevant page is as at 20 December 2016 and may have changed since. Issued in the UK by Record Currency Management Limited. This material is provided for informational purposes only and is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities, Record Currency Management Ltd products or investment services. There is no guarantee that any of the strategies and techniques will lead to superior investment performance. All beliefs based on statistical observation must be viewed in the context that past performance is no guide to the future. There is no guarantee that the manager will be able to meet return objectives and tracking error targets. Changes in rates of exchange between currencies will cause the value of investments to decrease or increase. Before making a decision to invest, you should satisfy yourself that the product is suitable for you by your own assessment or by seeking professional advice. Your individual facts and circumstances have not been taken into consideration in the production of this document.

Hedging risk warnings

Hedging foreign exchange risk is typically undertaken at periodic rebalance points so that exposures and hedges are rebalanced to reflect the new information. Interim drift between hedged positions will take place because of market movements or because of tactical asset allocation changes in the currency composition of the underlying assets. In addition, hedges are generally rebalanced around certain tolerance levels. These factors will create divergence between the hedge returns and the currency impact on the underlying assets. In addition dealing costs must be taken into account. Further divergence can be caused by proxy hedges where the proxy currency and the underlying currency move relative to one another. Finally, it is generally the case that not all currencies in the portfolio will be hedged or proxied. This is typically the case where there the cost of hedging or the lack of a proxy currency becomes a factor. The nature of hedging means that there will be intermittent cash flows which can be large monetary amounts positive and negative. Actual account set up will depend on each client’s unique requirements to manage cash flows.

Multi-Strategy

The Multi-Strategy product involves passive allocation to strategies during which positions are bought and held. Exposure is maintained to the selections between the periodic rebalancing dates and is not altered due to market factors. The Multi-Strategy product is made up of an allocation to a number of the underlying strategies which may also be invested on a standalone basis.

Emerging Market Strategy

Emerging Market currencies are typically subject to greater country-specific risks than developed market currencies. As a result of this and other factors, Emerging Market currency pairs are typically more volatile than developed market currency pairs. In addition, many (although not all) Emerging Market currencies are invested in through Non-Deliverable Forwards (NDFs), which are cash settled, and the pricing of which is less deterministic than for deliverable forwards. Investment in Emerging Markets tends to be more volatile than more mature markets and the value of your investments could in some circumstances move sharply either up or down. In some circumstances currencies may become illiquid which may constrain the investment manager’s ability to realise the investment. Political risks and adverse economic circumstances are more likely to arise putting the value of your investment at risk.

A rational currency allocation

  • Do market capitalisation driven weights make sense from a currency perspective? If not, how can we go about getting closer to a more balanced and optimal currency mix as part of international asset allocation?

Much has been written about the long-term, zero-sum game nature of a random allocation to currencies (via international equity and bond exposures). We do not wish to revisit this debate here suffice to say that, in general, an allocation to developed market currencies arising as a consequence of an international investment will tend to introduce an extra source of volatility for no discernible return over the long run, certainly from a US Dollar perspective.

What about for emerging market currencies?

We would contend that because of the Balassa-Samuelson effect, countries that are on a growth convergence path to developed market GDP (per capita) levels will see their exchange rates appreciate in real terms over time. Thus, any particular allocation to EM currencies via international debt and equity investing will also add value to, for example, an American or Japanese investor over time. While this may indeed be the case, can we do better? To put it slightly differently, do market capitalisation benchmark driven weights make sense from a currency perspective? We would argue they do not, simply because currencies are fungible and the likely appreciation path of a currency is independent of its relative economic size if there are indeed productivity advances to be experienced.

Consider the table below which ranks the constituent countries of the MSCI EM index by their weight in such an index (first column) and associates these with a “fair value” valuation (second column) versus the US Dollar.

How do we determine valuation or fair value here? We estimate this using a cross-sectional linear regression of 59 countries. The regression estimates the observed relationship between productivity growth rates and the spot exchange rate relative to Purchasing Power Parity (PPP is sourced from the OECD). Using the regression outputs (intercept and coefficient), we generate ‘productivity adjusted’ purchasing power parity exchange rates for MSCI EM countries using respective GDP per capita levels as inputs. The newly adjusted fair values are then evaluated against prevailing spot exchange rates to arrive at a final valuation estimate. This methodology attempts to correct for the main pitfall in Purchasing Power Parity valuations for emerging market currencies, whereby less developed countries exhibit structurally weaker exchange rates. In the table below, valuations are calculated as the overvaluation of the real exchange rate versus the “fair value” as described above and a negative valuation indicates undervaluation.

Now, if we look at the MSCI EM weighted valuation (valuation times country weight in the index) for each of the countries in the table, we arrive at an overall overvaluation of EM currencies to the tune of 1.7% as of September 2016 (fourth 4). What is more revealing is that a simple re-allocation of these weights to equal weights results in an undervaluation of EM currencies to the tune of 8.5%. In other words, passively buying the MSCI EM index results in a much more expensive currency mix than would otherwise be implied by a simple, equally weighed exposure.

The key takeaway here is that while an equally weighted EM currency exposure is by no means definitive or optimal in itself, exposure to a more diversified and growth oriented currency mix is a big step towards achieving that optimality. We refer to this exercise, in general terms, as currency recalibration : it has spurned further and fruitful research into combinations of valuation, carry and momentum (core factors) that are able to deliver enhanced portfolio efficiency relative to the currency mix embedded in market cap driven investing.

 

msci

Source: Macrobond, OECD, IMF WEO, Record.

Where are we in the dollar cycle?

  • The US dollar is at an inflection point. Can the dollar’s cycle continue in the face of convergent economic fundamentals and central bank coordination?

US policy rate normalisation does not guarantee dollar strength – real interest rate support crucial

The US dollar is at an inflection point. On one hand the real exchange rate is yet to comfortably pass its long run average, implying further room for appreciation, while on the other the humdrum chorus of gloomy global economics and a false hopes for US rate normalisation could threaten to pour water on the fire. Indeed, Fed watching has become a favourite pastime for many, presumably in the hope of uncovering clues as to the dollar’s next step, however focusing on the Fed alone is unlikely to uncover the dollar’s secrets. Unfortunately, Fed normalisation cycles alone have never truly been enough to predict a sustained appreciation in the US dollar, and there is no discernible relationship between US rate normalisation, and the nominal or real exchange rate (figure 1). This is natural as currency is and always will be a relative concept.

With this in mind, and given small differences in the level of development between the US and most other developed markets, real interest rate differentials can help us to determine the dollar’s true attractiveness and in turn explain a good deal of behaviour in the medium run (in fact, interest rates and price differentials form the basis for most currency valuation models).  Increasing real interest rates (ceteris paribus, of course) help drive the dollar higher but this effect is more prominent in longer-dated real interest rates than shorted dated. The message one could take is that short term real interest rate normalisation is a necessary but not necessarily sufficient condition for dollar strength, and the US dollar’s destiny may be determined more by elusive long-run forces, in other words natural real interest rates.

twi

real-rates

Figure 1 and figure 2. Source: Macrobond, J.P. Morgan

Is there scope for real rate divergence?

In view of the theory that US dollar appreciation requires an ascension of US real interest rates relative to the rest of the world, the US dollar cycle may have hit a stumbling block. Declining natural real interest rates have been a global phenomenon (the BIS here and BoE  here have written extensively on this topic), with lower growth, a savings glut and rising inequality as cited culprits. For significant divergence in the long-end of the curve, these fundamentals in the US need to improve. This will be a challenge; even the Federal Reserve has been forced into submission by the secular stagnation thesis as the bank’s long-run projections of interest rates have continued to shift towards that of the market. A similar reality is also evident in the short end of the curve; forward guidance, global economic coordination and increased responsiveness to shocks by central banks are creating fewer economic surprises, fewer opportunities for divergence, and are suppressing interest rate and currency volatility (figure 3).

surprises

Figure 3. Source: Bloomberg, Macrobond, Citi Economic Surprise Index

Can the world cope with a stronger dollar?

While the bar for a stronger dollar would seem high, we believe the US can cope with a stronger dollar, and economic impacts should not hold the cycle back. The US economy is relatively closed with trade making up only 30% of GDP, therefore a stronger dollar is unlikely to pose a large threat to growth via the trade route. Additionally, we should not be too concerned about the currency’s impact on inflation in the US; currency pass-through to inflation is  the lowest among G10 economies (figure 4), in part due to the limited degree of openness but also because the vast majority of US imports are denominated in dollars, limiting the impact on inflation to volume effects only (as foreign imports are diverted elsewhere). 

We think that the rest of the world can too cope with and may indeed benefit from a stronger dollar. Firstly, most developed economies are not troubled by high inflation and would likely welcome a boost in price levels. In particular, the Bank of Japan and European Central Bank are plagued by currency strength and diminishing returns to ever expanding easing programs. In the Emerging Markets, a stronger dollar is not quite what it used to be; most sovereigns have reduced hard currency borrowing significantly, and while in some countries corporates may still be exposed to fx liability risk, EM central banks boast larger foreign currency reserves than in previous hiking cycles, and governors that are more adequately equipped skill-wise to deal with all the economic shocks that a stronger dollar would bring. 

fx-passthrough

Figure 4. Source: “The International Price System” , Gita Gopinath (2015). Eurozone is an average of Italy, France and Germany

Have currency markets become more choppy recently?

  • Are currency markets stuck in a period of short-term mean reversion? If so, what’s driving this and what are the implications for investors?

One straightforward way to look at the level of mean-reversion (‘side-wayness’ as opposed to ‘trendiness’) in an asset over a given period is to look at the so-called Vertical Horizontal Filter (VHF). In essence, this measure computes the difference between the highest and lowest level in the asset price and divides this by how many ‘steps’ it took on the path to get there. The VHF measure was developed in the early 1990s and a low measure would indicate a choppy market, whereas a high measure would indicate a trending phase. In terms of our own preferred definition, mathematically it is : VHF = (Max({Spot in 250 days}) – Min({Spot in 250 days})) / (SUM_{t=2}^{250} (Spot(t) – Spot(t-1))). In other words,  the numerator is the absolute value of the highest close minus the lowest close over the course of a year. The denominator is the sum of the absolute value of the difference between each day’s price and the previous day’s price over this same year.

Below we show the VHF measure for the most liquid currency relationship, namely, the EURUSD cross. The chart shows that we have been in a mean reversion period for most of this year, with effectively this pair trapped in the 1.05 to 1.15 range. Why so? We argue that the Fed backtracking over the trimming of their second rate rise this year has had an impact in dampening further prospects for US Dollar appreciation. At the same time, although the Eurozone has engaged in an expanded QE programme, inflation remains low, and so real interest rate differentials between Europe and the US are not large. The market is now, we believe, pricing in new normal or “neutral” real interest rate (1%) that is much lower than in the past (2%-3%) and this is reflected in flat forward curves in interest rates. This applies to both currency blocks. What do we need for this mean reversion to stop and a new equilibrium to be found? We believe that real rate expectations need to be dislodged from their current static equilibrium and, if so, most currency pairs, including EURUSD will find new equilibrium levels as real interest rate differentials act as drivers of spot rates going forward, something that has been driving Emerging Market currencies of late in fact.

VHF

 

 

What next if negative rates fail

  • In response to almost a decade of QE and with little discernible effect, central bankers have now resorted to negative interest rates. What is the zero lower bound and are below zero rates having the desired effect?
  • If negative interest rates fail to halt deflationary momentum, could more extreme options such as ‘helicopter money’ be a viable next step?

Negative interest rates can now be seen across the developed world, ranging from -0.1% in Japan to -0.75% in Switzerland. As more central banks dive into negative territory and with other such as the BoE not ruling the option out, it raises questions such as how low can negative rates go, and are negative rates effective in stimulating demand? In answer to the first question, theory goes that since cash holds an implicit carry of zero percent, the zero lower negative bound should be equal to the cost of insuring and storing the cash. In reality, the zero lower bound may be unlimited. If banks were to create additional charges for withdrawing cash exactly proportional to the negative interest rate on offer, the monetary benefit of withdrawal would be zero. To make things even more difficult for cash hoarders, in years to come there may be no cash to hoard; on the 15th February the ECB council voted to scrap 500 Euro notes, which represent around 30% of notes in circulation. In a cashless economy there is technically no lower bound.

Policy Rates

It would appear that whether negative rates work is directly related to the ability of savers to withdraw their deposits. In a world where there are no barriers to deposit withdrawal, negative interest rates could reduce the pool of loanable funds in the banking system and push up nominal interest rates. Of course, central bankers understand this, which is why we can expect to see further attempts to move towards a cashless economy. Already, negative interest rates are having unintended consequences. For example, most banks affected are showing reluctance and or the inability to pass on negative rates to depositors, while flatter yield curves from central bank bond purchases erode earnings on longer duration assets, hitting the bottom line through net interest income. When QE and negative interest rates are supposed to spur credit creation and animal spirits, fragile banks profitability and rising risk premiums will not help the cause. The Bank of Japan in its most recent move argued that the channel by which negative interest rates work is through asset reallocation and inflation-friendly exchange rate depreciation. The logic is correct, but currency is ultimately a zero sum game, and with disinflation becoming a global epidemic, a beggar thy neighbor currency policy is destined to fail, unless others (the US) can successfully shoulder massive  currency appreciation.

If negative rates prove problematic, where will the next round of easing come from should we face another global downturn? One potential policy gaining traction in the financial world is ‘Helicopter Money’, a term coined by the economist Milton Friedman. Conventional QE as we know it, indirectly reduces government borrowing costs and is not permanent (newly created reserves eventually disappear as debt matures).  Helicopter money in a modern format would be permanent QE, directly financing government spending or tax cuts indefinitely by purchasing bonds specifically issued by the government, either in the primary market (unlikely) or through the secondary market (legally and politically more defensible). This process could provide the boost the world economy needs, but there are dangers that need to be considered before a central bank and government decide to take the plunge.

For helicopter money to work , firms and households need to believe that any extra income received is permanent and will not remain a liability to the treasury, to be funded by tax at a later date. This can only be achieved if the bonds are wiped from the central bank’s balance sheet altogether, forgoing future payment. This free money would be appear fantastic to politicians and budget setters, but the central bank would find itself insolvent. While insolvency is not technically an issue at a central bank, the new structure of the balance sheet means its interest paid on excess reserves would likely exceed interest received on its assets. In this case more reserves are required to cover any income shortfalls, the balance sheet would grow out of control, and the central bank inevitably loses control of inflation. The alternative is to keep interest rates low enough such that interest expense matches asset income and the bank continues business as usual. This however implies maintaining low interest rates for an extended period, and again would probably result in loss of control over inflation.

Looking at the bigger picture, we cannot escape the truth that we are in an new era of poor demographics and subdued productivity growth, where the need to de-lever private and public balance sheets hinders the ability to generate growth and inflation. The longer central banks wholly bear the burden, the more they will be pushed into a corner with few remaining options. For these reasons, helicopter money or other extreme options such as wide-scale debt write-downs may gain more support across the board, with the understanding that a reset or purge of some sort may be a painful but necessary course of action in the long run. In some sense it has already begun; when the Bank of Japan owns over 30% of government T-bills and bonds, with little hope of reversing course, can we call it helicopter money yet?

Holdings