Last July, the ECB took unprecedented action for a major central bank and reduced its deposit rate into negative territory. On its face, it is an unconventional idea that lenders should have to pay banks or other borrowers to hold their deposits rather than be paid interest. While central banks have held key interest rates at just above zero percent since 2008 with the aim of stimulating the economy, the ECB’s negative interest rate experiment has already produced some adverse effects such as spurning investors in the money market mutual fund space.
Few historical examples of negative nominal interest rates exist. Denmark and Sweden entered negative nominal interest rate territory in 2012 for a short period of time with the aim of repelling foreign investors from bidding up the Danish krone and Swedish krona as they were fleeing turmoil in Eurozone. Switzerland used negative nominal interest rates in the 1970’s, when it was trying desperately to dissuade capital from flooding the country as investors sought a safe haven from the ravages of global inflation and fears of Middle East instability.
European Central Bank Headquarters in Frankfurt, Germany. Photo: Peter Langer/Newscom
European Central Bank key policy interest rates
Source: ECB and Bloomberg
European money market funds shed assets by over 20% in response to negative yields
In normal times, most portfolio managers don’t have to be very concerned about their money market mutual fund holdings, generally using them for the sole purpose of cash management, while they focus on finding investment opportunities in the equity, fixed income, currency, and commodity markets. Since the ECB deposit rate hit 0% in June 2012, that narrative has changed significantly as European money market fund managers have had to scramble to prevent their funds’ net asset value from dropping below ($1), or proverbially “breaking the buck”, especially now that the ECB deposit rate has been negative since July 2014 and many yields have fallen below zero as well on sovereign debt in the Eurozone such as the short term interest rates on sovereign bonds in Germany, France, Ireland, the Netherlands, Austria, Finland and Belgium.
Goldman Sachs and J.P. Morgan, the world’s biggest provider of money-market funds, have both closed their European money market funds to new investors since the ECB overnight deposit rate hit zero in 2012. Blackrock, the world’s largest asset manager, has responded to negative yields recently by creating a reverse distribution mechanism for its ICE Europe Government Liquidity Fund so that when the fund pays negative interest, it does it by distributing negative shares, rather than losing value on a fixed amount of shares. If you had 10,000 shares and the European money market fund pays negative 0.1 percent interest, now you have 9,990 shares each worth $1, but your shares technically never lost value and will not break the buck even though the fund lost value overall.
The overall decline in assets of the money market fund industry speaks to how damaging hitting and crossing the zero lower bound into negative territory has been for the European money markets. Since the ECB deposit rate hit 0% in June 2012, the money market fund AUM has fallen by 20%. The Federal Reserve very astutely has kept the federal funds rate above zero, targeting 0.25% rather than 0%, for this very reason to avoid a similar fallout in the money market assets in the U.S.
IMMFA European Money Market Fund Industry Assets Under Management (in millions of €)
Source: IMMFA
Hitting zero at the zero lower bound causes banks to no longer keep their money at the ECB
When the ECB deposit rate hit 0% in June 2012, the amount of overnight deposit facility assets literally dropped in half the following day, falling from over 800 billion euros to below 400 billion euros. In many respects, this is the kind of result that the ECB wants to have happen, for banks to stop hoarding cash at ECB in their overnight deposit facility and start lending it to other banks, according to the FT.
ECB Overnight Deposit Facility Daily Liquidity (Assets in millions of €)
Source: European Central Bank
Interbank lending has dropped as well as since deposit rate was reduced to zero
However, according to the Bank of International Settlements, interbank lending across Europe has fallen as well since the ECB deposit rate hit zero in June 2012. We will have to wait and see if the trend continues in a negative rate environment which could be complicated by a round of quantitative easing currently being rolled out by the ECB.
Source: Bank of International Settlements
A possible shift to cash in the economy
As famously pointed out by Fisher Black in a seminal 1995 paper titled, "Interest Rates as Options”, the chief concern about negative interest rates is that holding cash can achieve a higher return. With the existence of currency, if negative interest rates could are imposed on lenders it is optimal for them to move to cash to avoid such a negative return. Such an outcome has been observed historically when Switzerland when it had prolonged negative nominal interest rates in the 1970’s. As a result, the monetary base (the amount of cash held in the economy) grew enormously while other components of the money supply remained relatively stable.
Switzerland Monetary Base (1971-1985)
Source: Cato Journal, Swiss National Bank
Since June 2012 when the deposit rate hit zero, we’ve seen an expansion in M1 (which includes currency and deposits) which may continue to grow relative to the components of M2-M1 in a negative interest rate environment if people decide to move to cash rather than take the negative yield. Some banks in Europe have already announced that they are charging negative interest rates on deposits.
Euro Area Monetary Aggregate Growth In M1 (Currency and Deposits) and M3
Source: ECB
Larry Summers and Ken Rogoff believe negative nominal rates make sense only in a cashless society
In late 2013, Larry Summers gave an important speech at the IMF Research Conference on the zero lower bound, explaining that the Fed cannot cut the nominal rate below zero because people will choose to hoard money instead of putting it in the bank. A new NBER Working Paper from Ken Rogoff goes into more detail about the zero lower bound problem that cash creates which is summarized well by the Wall Street Journal. William Buiter, the chief economist of Citigroup, has also written an excellent NBER Working Paper on the subject. The Federal Reserve very astutely has kept the federal funds rate above zero, targeting 0.25% rather than 0% or a negative rate, for this very reason: to avoid the outcome of individuals potentially hoarding money as opposed to spending or investing it in addition to avoiding the problems created for money market mutual fund assets which fall under the M3 monetary aggregate.
How low can they go below zero?
In a negative nominal interest rate environment, there is the question of why banks don’t just hold banknotes in a warehouse somewhere to avoid the negative yield? Of course, that’s something that the ECB is well aware of, as they note on their website that “holding cash is not cost-free either − not least since the bank needs a very safe storage facility to warehouse the banknotes”. Since there’s a cost to holding cash, as long as the negative interest rates don’t exceed this cost, it makes sense for banks to bite the negative yield by either lending money to other banks or pay the negative deposit rate. If European interbank lending yields continue to be negative, we'll see how long that lasts.
