From ZIRP to NIRP
It will hardly be news to readers of this column that interest rates on most of the leading currencies are extremely low, verging on zero – and have been that way for some time. Years, in fact : the Federal Reserve and Bank of England cut their interest rates down to very near zero during the crisis of 2008-09, and since then they have not raised short-term rates, but have instead sought to push down the rates of interest available in the market for government debt of steadily longer duration – first up to one year, then out to two years, and so on.
The ECB, when it was still under the influence of the Bundesbank, tried to raise rates as the European crisis intensified, but under the presidency of Mario Draghi it has reversed its policy stance and is now pushing rates down. As for the Bank of Japan, it has spent some 15 years in an ongoing – but futile – efforts to counter the entrenched deflationary pressures at work in the Japanese economy by holding short-term interest rates near zero and buying longer-term bonds.
This policy position is known by the acronym ZIRP – zero interest rate policy. In practice, none of these central banks, not even the Japanese one, has actually dropped the rate of interest it charges banks to borrow from it to absolute zero. But near-zero rates have had significant side-effects, and these have not necessarily been the ones the central bankers aimed for – namely spurring new business lending by commercial banks. The ultra-low interest rates available to savers has meant that anyone seeking to live off their savings has been heavily punished, and the cumulative impact on pension savings is a very serious matter in its own right.
Nevertheless, the ZIRP policy remains in place, and there has been much talk recently of a move to NIRP – negative interest rate policy, in which central banks will lend accept deposits from commercial banks only if the latter pay the borrower to accept their money. This sounds off-the-wall, but it is a reflection of a situation in which countries are being divided into two groups – those seen as capable of repaying their debts, and those seen as likely to default. As the situation of the weaker countries — notably the PIIGS group of periphery countries in the eurozone – deteriorates, there has been a huge shift of funds from them to strong countries, both within the eurozone and outside it.
The result of this capital flight from crumbling banking systems, economies and countries to those perceived to be more stable, has been to create extraordinary imbalances and unprecedented strains on the international financial system. These imbalances are expressed by the amazing interest rate differentials between the two groups of countries. Germany, along with Holland, Finland and Denmark – and of course Switzerland — were able to issue new bonds offering zero interest rates. People were happy to park their money with these governments for no return whatsoever.
The Swiss were the first to go beyond zero rates. The Swiss have spent the last year defending the exchange rate of 1.20 franc to the euro that they declared unilaterally, after the franc soared in value to parity with the euro. This policy forces them to buy huge quantities of euro and sell francs, and to issue government bonds to “mop up” the excess francs. But so great is the demand to hold francs that interest rates on short-term Swiss government paper has turned negative. People are paying the Swiss government for the honour of lending to it.
Now, however, this supposedly incredible and irrational phenomenon is not limited to Swiss government paper. On the contrary, the list of countries in which the market has pushed interest rates for bonds of as long as two years duration – not just Treasury bills — into negative territory is steadily expanding and, on Tuesday of this week, included Germany, Holland and Denmark, as well as Switzerland. The yield on two-year bonds of eight other countries — USA, UK, Japan, Canada, Sweden, France, Austria, and Finland — was at less than one per cent. Meanwhile, the yields on bonds of the troubled countries, such as Spain, continue to climb – because no-one wants to buy those countries’ debt.
In other words, the rate of return being offered on government loans is no longer a primary factor in determining investment decisions. As we have noted here so often over recent years, what matters more and more is ‘return OF capital’ – whether the borrower will repay the money lent to him – and not ‘return ON capital’, or the rate of interest the borrower offers the lender for the duration of the loan.
This state of affairs seems not just weird, but unsustainable. That may be so, but it’s worth remembering that Treasury bill yields in the US, which are also around zero today, traded at that level for several years in the late 1930s. Remember, too, that if indeed the developed economies are slipping into deflation, then zero is actually a positive real return.