How central banks can take nominal rates deeply negative

The popular view that nominal interest rates have a natural zero lower bound has become obsolete in modern financial systems. It may be more appropriate to consider this boundary a convenient policy choice that can be revised. Technically, the zero lower bound arises from potential arbitrage at negative nominal rates, in the form of cash withdrawal, storage and redeposit. However, the central bank can break this arbitrage by using its power at the cash window, i.e. by altering the conditions at which commercial banks can withdraw and redeposit paper money. There are two viable options for doing so. The so-called ‘clean approach’ creates a crawling exchange rate between paper money and electronic money, effectively devaluing the former relative to the latter at a predictable continuous rate. The so-called ‘rental fee approach’ charges commercial banks for using paper money and is equivalent to imposing negative rates on cash held by the private sector.

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The duration extraction effect

Under non-conventional monetary policy central banks influence financial markets through the “portfolio rebalancing channel”. The purchase of assets changes the structure of prices. A particularly powerful portfolio rebalancing effect arises from duration extraction, i.e. the combined size expansion and duration extension of the assets that have been absorbed onto the central bank’s balance sheet. Duration extraction has a significant and persistent impact on the yield curve and the exchange rate. Importantly, the effect arises from hints or announcements of new parameters for the future stock of assets. Given the large size of central bank balance sheets, this explains why changes in expected asset purchases, re-investments or redemption plans have a profound impact on financial markets.

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Tiered reserve systems

Negative monetary policy rates can undermine financial transmission, because they encourage cash hoarding and reduce the profitability of traditional banking. This danger increases with depth and duration of negative interest rate policies. Therefore, some countries (Japan, Sweden, Switzerland, and Denmark) have introduced tiered reserve systems, effectively exempting a part of the banking system’s excess reserves from negative rates. Importantly, a tiered reserve system is now also considered by the European Central Bank for the second largest currency area in the world. Since tiered reserve systems are on the verge of “going mainstream” their impact on asset pricing formulas and quantitative trading strategies deserves careful consideration.

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ECB policy framework in six basic points

The European Central Bank is one of the most powerful institutions in the world and is running a particularly complex policy framework. For macro trading and financial modelling, the following points are critical: [1] The primary policy objective is medium-term inflation, with a horizon of two years or more and symmetric aversion to deviations from a mean of just below 2%. [2] In practice, policy rate setting has followed a simple dynamic Taylor-type rule. [3] The operational framework is very broad, with a wide range of counterparties and instruments. [4] The ECB has extensive experience with four types of non-conventional policies (long-term lending operations, asset purchases, negative interest rates, and forward guidance) that jointly exercise powerful influence on financial conditions. [5] The effectiveness ECB policy depends critically on coordinated national fiscal and regulatory policies. [6] Special mechanisms have been put in place to contain redenomination risk, i.e. fears that assets might be redenominated into legacy currencies.

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How convenience yields have compressed real interest rates

Real interest rates on ‘safe’ assets such as high-quality government bonds had been stationary around 2% for more than a century until the 1980s. Since then they have witnessed an unprecedented global decline, with most developed markets converging on the U.S. market trend. There is evidence that this trend decline and convergence of real rates has been due prominently to rising convenience yields of safe assets, i.e. greater willingness to pay up for  safety and liquidity. This finding resonates with the historic surge in official foreign exchange reserves, the rising demand for high-quality liquid assets for securitized transactions and the preferential treatment of government bonds in capital and liquidity regulation (view previous post here).

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Low rates troubles for insurances and pension funds

A CGFS report highlights the pressure of a ‘low for long’ interest rate environment on life insurance companies and defined-benefit pension funds. This pressure reflects a fundamental mismatch: the duration of liabilities is greater than that of assets. Hence low rates (discount factors) have reduced funding ratios below 100% after the great financial crisis. Simulations suggest that funding ratios could decline further, possibly accompanied by negative net cash flows. A ‘low-for-long’ scenario would broadly make things worse. While the nature of this risk is well known, its manifestation is gradual and partly mitigated by the asset reflation of the 2010s. The worst scenario for insurance companies and pension funds is one where rates ultimately fail to rise or are pushed even lower (negative) due to new deflationary financial market shocks.

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Policy rates and equity volatility

Measures of monetary policy rate uncertainty significantly improve forecasting models for equity volatility and variance risk premia. Theoretically, there is a strong link between the variance of equity returns in present value models and the variance short-term rates. For example, there is natural connection between recent years’ near-zero forward-guided policy rates and low equity volatility. Empirically, the inclusion of derivatives-based measures of short-term rate volatility in regression forecast models for high-frequency realized equity volatility has added significant positive predictive power at weekly, monthly and quarterly horizons.

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Monetary policy stance in one indicator

New research proposes to condense policy rates and balance sheet actions into a single implied short-term interest rate. To this end the term premium component of the yield curve is estimated and its compression translated into an equivalent change in short-term interest rates. This implied short-term rate can be deeply negative and allows calculating long time series of the monetary policy stance including times before and after quantitative easing. It is only suitable for large currency areas, however. Indicators of smaller open economies should include the exchange rate as well, as part of an overall monetary conditions index.

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The consequences of increased financial collateralization

There has been a strong upward trend in collateralization since the great financial crisis. Suitable collateral, such as government bonds, is essential for financial transactions, particularly repurchase agreements and derivative contracts. Increased collateralization poses new risks. Collateral prices and haircuts are pro-cyclical, which means that collateralized transactions flourish when assets values rise and slump when asset values decline. This creates links between leverage, asset prices, hedging costs and liquidity across many markets. Trends are mutually reinforcing and can escalate into fire sales and market paralysis. Central clearing cannot eliminate this escalation risk. The collateral policies of central banks have become more important.

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Critical transitions in financial markets

Critical transitions in financial markets are shifts in prices and operational structure to a new equilibrium after reaching a tipping point. “Complexity theory” helps analysing and predicting such transitions in large systems. Quantitative indicators of a market regime change can be a slowdown in corrections to small perturbations, increased autocorrelation of prices, increased variance and skewness of prices, and a “flickering” of markets between different states. A new research paper applies complexity theory to changes in euro area fixed income markets that arose from non-conventional policy. It finds that quantitative indicators heralded critical structural shifts in unsecured money markets and high-grade bond markets.

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