In a Negative Rate World, Cash is King

If you don't understand how negative interest rates work yet then you should probably learn quickly.  The stock markets are, once again, close to an all time high and the economy is (depending on who you talk to) booming. However, the Federal Reserve has been signalling there could be the possibility of a rate cut, or in fact a few of them. But with yields already historically low, the Fed does not have much room to manoeuvre (before they hit zero), especially if they find themselves having to battle another recession. 

As we saw during the last crisis of 2008, many central banks reduced policy interest rates to zero to boost growth (It is interesting to read, some 9 years later, Ben Bernanke’s Washington Post Op-Edon why the Fed did what they did). Since then, we have seen many of them take it a step further and implement a “negative” interest rate policy. 

The amount of negative-yielding government bonds outstanding through 2049 has risen by 20% this year alone. In fact, there is now more than $11 trillion in negative-yielding debt, which means that roughly 30% of developed countries’ sovereign debt yields less than zero. Roughly 6.7 Trillion of the total currently comes from Japan and 3.8 Trillion comes from Europe. Another 800 billion is credit related. 

So what exactly is a negative rate? Think of when you open up a deposit or savings account at your bank, the bank offers you interest for keeping your money with them. Over the years, this interest accumulates and your bank account grows. It is the fee the bank pays you for the opportunity to use your money (see Who Owns the Money in your Bank Account: Hint, it is not you). Equally, you can also purchase government bonds (you lend the government money) which in return will pay you interest over the life of the bond. In the case of negative interest rates, instead of receiving money on deposits, depositors must pay the bank a fee for the luxury of keeping their money there on deposit. That’s right, you deposit money in your bank account and the bank not only uses your money but they take a portion of it for themselves. 

The main reason central banks implement such a policy is to drive investors out of safe assets into risky assets with the intention of crowding out investors to try and jump start the economy. Results of low rates are a weaker currency which helps exporters of that country’s goods, which in turn helps power the economy. Switzerland was the first government to charge a negative interest rate. It implemented this policy between 1972 and 1978. The reason they adopted this strategy was to help stabilize the economy and to prevent its currency from rising too much from foreign investors buying its currency.

But why would anybody want to purchase bonds with a negative yield? As the Financial Times pointed out, “The idea of investing in bonds where you are guaranteed to lose money — if you hold them to maturity — has always seemed paradoxical. But it begins to make sense in a world where you are sure to lose even more money if you stick the cash in a bank.” Notice they said, “if you hold them to maturity”. If you purchase a negative yielding bond with the outlook that rates will continue to get even more negative, then the holder’s of the bonds can walk away with a gain as the price of the bond increases as yields continue to decrease. 

In turn, why would you want to keep your money in a bank that not only does not promise you a return, they charge you a fee to keep your money there? The truth is you probably would not. When a central bank has a negative interest rate, it means that commercial banks have to pay a fee whenever they deposit money into the central bank's reserves. The commercial bank then makes the decision to pass on those negative rates to the clients of the bank.

If they do not pass on these rates, the negative interest rates therefore result in a direct decline in interest margins for the bank, and result in a decrease in profitability. Competition between the banks and the option for clients to hold liquidity in cash do not allow for the negative interest rates to be passed on to individual clients. The bank essentially takes the hit. In addition, they know that there is a good chance that customers would flee in large numbers to the nearest bank offering a positive rate of return. So you would imagine that banks would never do it. Wrong!

When the SNB first initiated their negative rate policy, it didn't take long before banks chose to pass the charge onto their customers. The Alternative Bank was the first Swiss retail bank to implement negative interest rates. It charged negative interest of 0.125% on up to 100,000 Swiss francs held in a private account and 0.75% for amounts in excess of 100,000 francs. PostFinance, the Swiss postal bank, was the second retail bank to implement a negative interest rate. The negative 1% annual interest rate applied to customers who hold more than 1 million francs of savings in PostFinance accounts. The Zürcher Kantonalbank (ZKB) introduced a  negative 0.75% annual interest rate for specific high-net-worth customers.

In 2017, UBS introduced fees on big euro deposits held by private clients at the Swiss bank. The move was in response to negative interest rates levied by the European Central Bank on cash deposits.

The IMF Blog pointed out that, “One option to break through the zero lower bound would be to phase out cash." They go on to say that by doing so, “Central banks would have much more flexibility in policy as they could easily reduce the rate from 2 percent to negative 4 percent to counter a severe recession. The interest rate cut would automatically transmit to bank deposits, loans, and bonds.” Without cash, depositors would have to pay the negative interest rate to keep their money with the bank, making consumption and investment more attractive. This would jolt lending, boost demand, and stimulate the economy.

When cash is available, as is the case in many countries, cutting rates significantly into negative territory becomes much more difficult. Instead of paying negative interest, one can simply hold cash at zero interest. Cash is a free option on zero interest, and acts as an interest rate floor. 

If negative interest rates are to become a long term reality whereby the banks are free to charge customers as they wish, cash will have to be removed from society. As long as cash still circulates in society, banks are at a disadvantage and will risk a run on the bank should they attempt to charge depositors negative rates. However, beware, because negative rates, first designed as a short-term jolt, have now become an addiction.