Time For Some Mattress Padding

Submitted by Bryce McBride via Mises Canada blog,

Can you imagine borrowing $1000 from the bank and receiving $10 per year interest from the bank? I didn’t think so. However, this is the happy situation facing some European countries and even a few Swiss companies. The Swiss, Swedish, and Danish governments and the food multinational Nestle are now borrowing money from lenders who are happy to pay them for the privilege. In what may signal the beginning of the end of the current financial system, we have moved beyond zero percent interest rates to negative interest rates.
Why are negative interest rates now making an appearance? They are a natural consequence of the rampant money creation undertaken by central banks in response to the global financial crisis. To look at Switzerland, as European savers lost confidence in the euro in 2010 and 2011 and started converting their euro into Swiss francs, the value of the franc against the euro began to rise rapidly. This increase in the value of the franc made Swiss-made products expensive compared to French- or German-made products. In order to keep Swiss companies in business (and Swiss workers in jobs) the Swiss National Bank committed to keeping the value of the franc at or below 83 euro cents.
In order to do this, it was necessary for the Swiss National Bank to do two things. First, it created billions of additional francs and exchanged them for euro on the foreign currency markets. Second, it set Swiss interest rates lower than European interest rates in order to make Swiss bank deposits unattractive to European savers and Swiss loans attractive to European borrowers. European companies and thousands of people in countries like Austria and Hungary, attracted by lower Swiss interest rates, took out loans and mortgages denominated in Swiss francs. These francs were then sold on the foreign exchange market in order to buy the euro needed to fund investment or buy property. The increased supply of francs courtesy of the SNB and European borrowers and the reduced demand for francs from European saver kept the value of the franc suppressed against the euro.
However, as the European Central Bank has responded to each new crisis with promises of additional money printing, last month the Swiss National Bank, no doubt alarmed at the prospect of having to accelerate their own program of money printing in order to keep pace, surprised investors by announcing that they would no longer intervene in the foreign exchange market to keep the franc’s value fixed against the euro. Almost instantly, the franc gained 30% against the euro before settling at around par.
This sudden policy reversal resulted in large losses. Perhaps the biggest loser was the Swiss National Bank, which saw its holdings of euro and euro-denominated assets lose 20% of their value in terms of Swiss francs. Similarly, European companies and individuals who had borrowed in francs saw the size of their loans increase significantly in terms of euro. Eager to prevent further losses, European companies who had borrowed francs began purchasing francs in order to allow them to make future loan payments.
However, while you or I might buy franc notes, corporations with billions of dollars in assets prefer to purchase and hold money using liquid instruments such as government bonds. Thus, the demand for Swiss bonds exploded last month. As more and more investors competed to lend money to the Swiss, they began to accept lower and lower rates until the rate on a one-year Swiss government bond fell to around negative 1%. Put another way, investors who bought a Swiss government bond for 1000 francs would only get back 990 francs a year later, which makes one wonder why buy bonds at all? Why not just buy Swiss currency notes and keep them under your mattress? Asking this question gives some insight into the future of the global financial system.
In Switzerland, so long as people had confidence that the Swiss National Bank would keep the franc pegged at 83 euro cents, they were happy to borrow francs (at a low interest rate) to finance speculation in Europe. However, the minute the peg was broken this dynamic was reversed. Suddenly people who had borrowed in francs became desperate to hold franc assets with which to service their loans. They became so desperate that they were willing to accept negative interest rates.
As Switzerland has gone, so too will go Japan, the EU, the US and every other country that has engaged in reckless monetary expansion since 2008. For the past 6 years, monetary authorities have created trillions of dollars, yen and euro in order to sustain an illusion of stability and recovery. However, the near-zero percent interest rates that have resulted have caused even the most prudent of savers to behave like speculators in search of decent investment returns.  As a consequence, many stock market indices are at all-time highs and some individual stock market valuations are patently ridiculous – it was reported last week that a firm in California that operates four “gourmet” grilled cheese sandwich trucks was valued at over $100 million!
The fact is, though, that these valuations are almost entirely due to the efforts of central banks to, as Mario Draghi (the governor of the European Central Bank) put it a few years ago, “do whatever it takes” to bring stability to the financial markets. As investors know that whatever apparent stability that exists is dependent on central bank intervention, the minute that intervention ends (or is seen to be ending) there will be a rush to dump risky assets in favour of assets that will hold their value. The mania for yield irrespective of risk that has characterized markets for the past 6 years will instantaneously turn into a mania for safety irrespective of yield.
Sadly for many investors, there is a lot more newly-created money floating around the financial system than there are safe places to put it. As has happened in Switzerland, this will push interest rates on safe investments negative. As negative interest rates become steeper, people will begin closing their bank and investment accounts in order to hold cash. However, if there are not enough safe government bonds in the world to soak up the trillions of dollars that have been created with computer keystrokes over the past 6 years, there are certainly not enough bills and coins. A run on the banks would therefore be a catastrophe in which banks and central banks would fail and the savings of a great many people would be lost.
Interestingly, today is the third anniversary of the meeting of European finance ministers where it was agreed to bail out Greece for a second time to the tune of 130 billion euro. As can be seen from the headlines, economic conditions in Greece have only gone from bad to worse since then. The ever-more likely possibility of Greece leaving the euro zone is already causing individual Greeks to empty their bank accounts. The fact of a Greek exit could very well be the signal for investors worldwide to dump their risky assets and flee to safety. As in the globalized world of international finance a bank run or financial panic anywhere can easily become a bank run or financial panic everywhere, it might be a good time to give your mattress a bit of extra padding.