Switzerland’s experience of negative interest rates should give the European Central Bank pause.
The ECB is widely expected to cut rates when it meets on Thursday, taking rates, already at -0.20%, another 10 or 20bp further into the negative and expanding or extending its campaign of asset purchases.
While the threat of deflation in the eurozone is real, negative rates impose hard-to-mitigate costs, especially on the banking system. Like much medicine, low rates have perverse effects at extreme levels.
Switzerland in January took rates to -0.75%, and on the evidence, there has been only partial pass-through of lower rates, particularly to mortgage borrowers.
The thinking behind negative interest rates is based on the belief that as official rates fall, so will those in the market, making it cheaper and easier to buy, consume, build and invest. Yet negative interest rates punish the banking system, a particularly crucial and vulnerable part of the eurozone economy, and potentially undermine the expected impact of cheaper official money and create unwanted side-effects.
“This is a case of basing policy on models which assume what they need to prove,” writes Eric Lonergan, a macro hedge fund manager and economist. “The initial findings suggest that we should indeed be very careful about expecting our models to work as assumed.”
The interest rates on government bonds in Switzerland have plunged in reaction to official policy, with 10-year bonds yielding a record low -0.41%. But there is a disconnect between securities markets, over which central banks have much control, and private lending, which still requires that banks can turn an acceptable profit in order to function.
Andréa Maechler, a member of the governing board at the Swiss National Bank, noted in a November 19 speech that long-term mortgage rates in Switzerland are actually higher than they were at the beginning of the year, before rates were cut.
“This is because banks’ refinancing costs have not fallen to the same extent as money market interest rates,” Maechler said. “As a result, banks’ interest margins have come under pressure, and to partially offset this effect, banks have raised their mortgage interest rates.”
Who benefits?
Negative rates do not, at least to judge by the markets’ reaction, make banks a better credit to those who provide them with capital. Or, at least we can say that the market view of the risk of lending to banks has not in Switzerland moved lower as briskly as have money markets.
As it happens, higher mortgage interest rates were welcomed by the Swiss National Bank, which might reasonably have feared that negative rates might possibly inflate real estate prices in a dangerous or destabilizing way.
Swiss corporate bonds also failed to keep pace with the move to lower yields seen in government bonds, perhaps because holders of corporate debt have more choices, unlike so many holders of government bonds. This argues, if anything, for the potential of destabilizing market movement in negative interest rate regimes, as holders of debt rush toward anything with a positive yield, taking less care in the process.
Reuters reported last week that the ECB is considering a two-tiered approach intended to mitigate the impact of a cut in rates on banks, effectively making it more expensive to hold larger amounts of cash on deposit with the central bank. That, the ECB may hope, will encourage banks to lend instead. Yet despite a lesser penalty rate already being in place, eurozone bank lending can hardly be called booming.
Lending to households and companies are both at four-year highs, but we should remember that four years ago, things were not particularly great.
The ECB could simply buy bank loans, particularly doubtful ones, as a means to get them off banks’ books and free up funds for further lending. Yet the signs are mixed that there would be strong take-up on lending, were it more available.
Europe may eventually have a capital-driven economy over which ECB measures can exert more control. But its economy and banks are not there yet.
None of this is to say that the ECB should sit on its hands, a former practice it has thankfully abandoned. As rates move further into negative territory, it is fair to expect volatile and unpredictable outcomes.
(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication he did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)
