Negative interest rates are the next leg in a seemingly endless global currency devaluation game, says Morgan Stanley Investment Management’s Jim Caron and Marco Spaltro.
In late January Japan stunned the markets by introducing negative interest rates, following similar moves by Europe. Just how low can rates go? Much lower than they are now, argue Morgan Stanley Investment Management’s Marco Spaltro and Jim Caron.
The two global fixed income managers say most developed countries are locked in a game of competitive currency devaluation that probably won’t end until rates get so negative that inflation starts to inch up. How negative that is exactly, no-one knows. What’s certain is that bond investors now have to be experts in global monetary policy if they want to stay a step ahead of, and potentially profit from, central banks chasing each other in circles.
“It’s like central banks are playing a never-ending game of chess with each other,” says Caron. “All of these unconventional monetary tools are basically designed to depreciate currencies. But once one central bank makes a move, it forces the others to follow. When one currency goes down, other currencies valued against it go up. All they’ve been doing is passing disinflationary forces from one to the other.”
Negative rates are the next more aggressive leg in the game, which began with zero interest rate policies and Quantitative Easing (QE). Sweden, Switzerland and Denmark went negative on rates last year, after the European Central Bank dropped its deposit rate to -0.2% in 2014 and introduced a strong QE program in 2015. The ECB followed with another cut to its deposit rate in December 2015, to -0.3%. The Bank of Japan went negative in January; Sweden cut further in February and the ECB is widely forecast to cut rates again in March.
Spaltro and Caron argue in their report called Global Chess Game that QE and low rates have done little to boost developed economies, and nothing to move the needle on inflation. That’s partly because the export competitiveness and rise in import costs that a country should get from currency depreciation are barely felt before its neighbors depreciate their currencies in turn.
The Federal Reserve put a stake in the ground last year by raising rates 0.25%. But the Fed has since acknowledged that the US is not immune to global market turmoil and devaluations elsewhere. Fed Chairwoman Janet Yellen has noted that the dollar’s 20% appreciation over an 18 month period was a concern. There’s now virtually no expectation the Fed will raise rates four times in 2016, as it indicated last year. “Investors are putting the odds of even one hike this year at 50-50,” says Spaltro.
Having QE and zero interest rates over such a long period didn’t just fail to create inflation, it added to the problem, say Spaltro and Caron. “We would argue that part of the reason for low inflation is the same unconventional policies that are supposed to generate inflation – ultra low interest rates and easy money,” they say in their report.
Take the US. QE and zero rates inflated asset prices, but didn’t improve the confidence of corporates in the long-term sustainability of economic growth. No confidence means less capital expenditure, and less follow-on rises in the prices of goods and services. Instead, companies have boosted profits by using low borrowing rates to buy each other. They’ve also borrowed money to buy back shares paying higher dividends than the cost of the debt.
Workers watching their 401(k)s rise in value also didn’t translate into more shopping. US consumers have instead increased their savings.
So far there’s little evidence that negative rates do more good than harm, and in Japan’s case it hasn’t worked at all. A devaluation just after the Bank of Japan announced its -0.1% rate on new bank deposits disappeared within days, as investors kept buying up Yen to hedge against losses in other markets.
Caron is hopeful that negative rates will help to create inflation. “All bets are off of course if China’s economy crashes. But you would think that, eventually, global economies will reach a point where supply and demand balance out,” he says. “At some point industry, manufacturing and everything else will right-size itself to the current level of demand. When that happens prices will stabilize and inflation will eventually find its footing.”