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Final Report from Paris

March 31, 2015

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We’re back. For the last few weeks we have been immersed in the issues surrounding central bank interest rates around the world. The culmination of that work occurred in Paris at the GIC-BDF conference (see http://bit.ly/GICPF2015).

Those meetings specifically focused on the interest rate policies of the Eurozone’s European Central Bank (ECB) and of the US dollar zone’s Federal Reserve (Fed). Other central banks and countries were also scrutinized. While the primary rate observed was the short-term policy rate, we also examined and discussed other rates and their influences.

Here is a brief recap. Today the policy rate on an excess reserve deposit by a Eurozone bank at the ECB is minus 20 basis points (-0.20 percent). The ECB’s current policy is still developing, and we do not know where it will end up or when. We do know it is driving rates lower than they would otherwise be. It already is impacting all countries in the Eurozone. Greece is an exception because of its credit issues. Bulgaria is an example. Bulgaria is in the euro system and borrowed over 3 billion euros last week. New-issue bond maturities were 7, 12 and 20 years. The weighted average cost of the Bulgarian borrowing was below 3 percent. That is lower than the borrowing cost for an equal-duration tranche of Fannie Mae-guaranteed mortgages, denominated in US dollars. Bulgaria is a borderline “junk” credit denominated in euros. Fannie Mae is a US government agency proven by the financial crisis to be backed by the US government. The only reason Bulgaria is able to borrow more cheaply than Fannie is the existing and developing negative rate policy of the ECB.

Other negative rates in Europe include the Swedish policy rate of -0.25 percent, the Swiss policy rate of -0.75 percent, and the Danish policy rate of -0.75 percent. So the issue is not just the ECB. We expect more negative rates as the ECB’s 18-month policy commitment unfolds.

Negative rates change behaviors. Agents seek to get rid of cash because it has a cost attached to it. Example: there is growing evidence that those who are able are prepaying their taxes in Denmark. Where possible, companies are prepaying bills. That is the way one person or business transfers the cost to another. That is a sample of the distortion that happens when there is a penalty for holding cash in a bank.

Also, there is already some hoarding of physical cash. One billion euros in 500-euro notes needs about 1.5 cubic meters of space (Oxford Economics estimate). Security costs are estimated at 5 basis points, so negative interest rates induce agents to hold physical cash. Note that cash is the alternate form of liability on a central bank’s balance sheet; excess reserves are the other large liability. There are progressive levels of negative rates that cause a marginal shift to holding actual cash as an alternative to paying to store cash at the central bank. The more negative the rate, the greater the incentive to hold physical cash.

In the United States, the excess reserve deposit rate for an overnight transaction is plus 25 basis points (+0.25 percent). In the US, the Fed is engaged in internal debate over when to raise rates, by how much, and in what manner. See Cleveland Fed President Loretta Mester’s Paris speech for her views on this subject.

Let’s get back to Europe. French central bank governor Christian Noyer offered his views at the GIC-BDF conference in Paris. We will note that Noyer is one of the very few central bankers who has held an official position for the entirety of the Eurozone’s existence. He was the original vice president of the European Central Bank when it was launched in 1998.

In a critical and profound comment, Noyer added that,

There are many technical discussions. Some people would argue that the stocks of assets held by central banks matter more than the flows of purchases. Others would contend that the composition and size of purchases are the real levers. The issue boils down to whether an expansion in the monetary basis is enough to trigger credit expansion or whether the latter is correlated to banks willingness to expand credit and more importantly on the appetite of economic agents to borrow. Based on how monetary policies have been conducted for the past several decades, banks have always had the ability to expand credit at a given level of interest rate irrespective of the size of the central bank’s balance sheet. Being at the ZLB (zero lower bound) does not change that simple reality. Hence I would tend to argue that, given the transmission channels of an asset purchase program, its composition and length may matter as much as its size.”

We fully agree. Think about it this way. Is there a difference between a $1 million portfolio of 90-day Treasury bills and a $1 million portfolio of 30-year Treasury bonds? Both are the same size. Both hold US government riskless securities. Yet everyone would agree that their characteristics are quite different. In sum, duration matters. At very low interest rates, duration matters a lot.


The ideas and opinions expressed in this blog are those of the author, and they should not be perceived as investment advice or as any other kind of advice.

The preceding is a commentary by Cumberland Advisors and has been reposted with permission. Cumberland Advisors commentaries are available at http://www.cumber.com/commentary_archive.aspx.

Follow Cumberland Advisors on Twitter at @CumberlandADV.

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