One of the ironclad rules of finance ever since the advent of central banks, has been that the lower a sovereign's cost of money (i.e., interest rates), the weaker its currency. That simple identity is why ever since 2009, central banks have been rushing to the bottom in rates (and in many cases dropping below it) in order to punish their currency, boost their exports and stimulate their risk assets.
And yet as increasingly more central banks push their rates into negative territory, a stunning development has emerged - as Bank of America recently noticed, central bank policy rates no longer have an impact on G-10 FX rates! This is shown in the BofA chart below which shows that the rolling 12 month correlation of change in G10 FX to changes in central bank rates is now zero.
But before we get into the details of this unprecedented observation, here is a brief summary of the broader impact of negative rates.
As BofA's Athanasios Vamvakidis summarizes, negative rates are a form of financial repression, penalizing banks that do not extend enough credit, while at the same time financial regulations are not allowing banks to be particularly aggressive. If demand is weak to begin with, as for example because of a trade war and high policy uncertainty in other areas, negative rates could make things worse, by further reducing bank profitability. Even if banks extend credit under pressure, "the quality of such credit could prove to be questionable, eliminating market discipline, jeopardizing the banks' portfolio in the long term and leading to lower potential growth for the economy as a whole."
Indeed, as the most recent IMF summit demonstrated (see "The Verdict Is In: "Negative Rates Are A Huge Negative For Savers, Low-Income People, And Investors") , most central banks have acknowledged such problems, as well as risks from keeping policy rates negative for too long. In response, in an amusing deflection, they have often emphasized that rates are only temporarily negative and have tried to offset them, up to an extent, with a tiering system. To be sure, five years after the ECB first unleashed negative rates, it has only shown that it has to keep cutting rates more and more (as it did most recently last month), making a mockery of the "temporary" argument. Meanwhile, BofA's economists have correctly argued that policymakers and central banks questioning the effectiveness of negative interest rates reduce their effectiveness in a self-fulfilling prophecy. After all, monetary policy only works because those who are subject to it, believe in its functionality. This is also the reason why so many central bank skeptics correctly point out that monetary policy is like a religion.
Of course, it's not just negatives: perhaps the most potent argument in support of negative rates used to be that it helped weaken the currency, in turn supporting inflation and the economy.
However, in an amazing adjustment, BofA's head FX strategist, Athanasios Vamvakidis, now writes that he no longer believes this argument holds, at least not any more. The reason is so simple and intuitive, it is hardly a surprise why no economist figured it out before: "when many central banks have negative policy rates, they just offset each other in a race to the bottom, leaving their currencies broadly unchanged and staying with the negative side effects, making everyone worse off." As a result, as monetary policy actions are more powerful only when they signal that more could follow, limits on how negative policy rates can be could reduce their effectiveness. Or, as BofA concludes, instead of the market focusing on the negative rates, it focuses on the inability of central banks to push rates too much into negative territory.
What does it mean if BofA is right, and negative rates no longer impact currencies?
As Vamvakidis writes, two key developments happened this fall that makes his believe that this is a great opportunity for central banks to get rid of negative rates, without being concerned about a strong currency, given the side effects.
- First, the ECB cut depo rates even deeper into negative territory in September and EUR did not respond (Chart 1). Up to an extent tiering may have offset the impact of the depo rate cut, but if this is the case, then why cut in the first place?
- Second, the Riksbank signaled in its October meeting that it wants to bring rates back to zero, despite weak data, because of concerns from negative side effects, at the same time strengthening forward guidance promising to keep rates at zero for longer, and SEK also did not react much: the market has now priced the hike fully (Chart 2).
As shown in the charts above, in both cases, the currencies weakened sharply when the central banks introduced negative rates and remain at such low levels. However, it is now clear - at least to Bank of America - that negative rates (and bringing rates back to zero) do not affect FX anymore, at least not to the same extent as when they were introduced.
What about the most important central bank of all?
As BofA points out, the absence of correlation between rates and FX this year is also obvious in the case of the Fed. The Fed went from hiking four times last year to cutting three times so far this year. The market was pricing two hikes for the Fed when this year started, then moved to pricing four cuts this year and another four next year by mid-2019, and is now pricing only one cut for next year. And yet, the USD has remained broadly unchanged, with DXY actually slightly up so far this year!
Here BofA's FX strategists make another notable observation: With the exception of CHF, all currencies in economies with negative rate are undervalued, as they should be.
So even if bringing rates back to zero causes some temporary appreciation, most economies can afford it. The ECB in particular introduced negative depo rates when EUR was overvalued and EURUSD was at 1.38, compared with 1.11 today. In any case, it was introduced to avoid QE, given political sensitivities, but remained because of concerns that the currency could strengthen again otherwise. To BofA, "these arguments are not valid anymore."
BofA's conclusion is rather groundbreaking: if negative rates no longer impact relative FX strength, central banks may want to bring rates back to zero. Vamvakidis explains:
Any concerns about potential tightening of the monetary policy stance from bringing negative rates back to zero could be easily offset with stronger forward guidance, in our view. Our economists have long argued that the ECB should explicitly link policy rate hikes to core inflation reaching and staying at 2%. If the ECB was to bring depo rates to zero and at the same time introduce such strong forward guidance, we would not expect the EUR to strengthen.
In short, since negative rates don't work to depress rates and merely crippled bank profitability - as a reminder we first pointed out four years ago that negative rates "paradoxically" lead to more savings, not less - BofA says it is that it is time to just do a NIRP reset, or "jubilee", and push all rates that are currently negative to zero instead.
As Christine Lagarde takes over the ECB, such questions could become more relevant. As BofA points out, "the market seems to assume that Lagarde will be more effective in helping reach a consensus for fiscal policy stimulus and potentially relaxing some of the constraints of the ECB current monetary policy tools." However, BofA doubts that Lagarde will do more than just repeating Draghi's call for more countercyclical fiscal policy. Instead, the bank's FX strategists believes that Lagarde "may actually surprise by focusing more on improving the effectiveness of ECB policies, rather than just doing more of the same." And yet, not even Bank of America is confident enough in this unorthodox theory to change its house call to one where the ECB under Lagarde will bring depo rates back to zero. Yet even so, the bank urges that it is worth to start thinking about such a possibility.
If combined with stronger forward guidance, it may actually help the economy, keep the EUR weak and increase the effectiveness and credibility of the ECB.
In perfectly rational world, this may even work. The problem is that just like OPEC, the world's central banks can only coordinate as long as not one bank violates the terms of the agreement. And if the past decade has taught us something it is that when push comes to shove, central banks become political tools of the state (see the Bank of Turkey for the latest example), to be used by politicians in power to perpetuate their careers. As such any hope that central banks can agree among each other to cut only to zero and never below, is nothing but a pipe dream.