How the hell does a negative interest rate work?
http://feketeresearch.com/upload/Second ... r-2015.pdfSwitzerland as a role model for what’s coming to the rest of the World?
Ludwig Karl, Switzerland.
As per 15th of January 2015, the Swiss National Bank removed the currency peg it had held at Swiss franc
1.20/euro 1.00 since the end of 2011. In order to stop a massive inflow of capital it lowered interest rates to
–0.75%, or so it thought. Directly after the announcement the euro went down to around 0.80 francs. In the
meantime it has stabilised around roughly parity.
The author of this article will focus less on the currency markets – as the movements are there for everyone to
see – but more on the subtle consequences of negative interest rates in Switzerland.
1. Capital inflows to Switzerland despite negative interest rates.
Capital inflows into Switzerland have not stopped. There is still a massive demand for Swiss francs. The signal
to the market that there is no cap on the Swiss Franc anymore led to market participants speculating heavily on
further appreciations of the Swiss franc. The cost of -0.75% in negative interest rates has not stopped capital
inflows which lead to an:
2. Ongoing intervention of the Swiss National Bank to devalue the Swiss Franc.
Still – even though the peg was officially ended – the SNB heavily intervenes in the Swiss franc currency
market. It buys euro and dollar denominated assets in order to artificially devalue the Swiss franc – or at least
to prevent an accelerating appreciation.
3. Negative rates on Swiss Govt. bonds – up to 10 years.
With the announcement of January the Swiss Govt. bonds instantly went into negative territory up to a 10y
maturity. The whole government sector can now borrow money up to 10 years and is paid for it.
Current 90-day rates are even lower than the base rate, standing at -1.05%.
4. Bank notes (with no negative interest rates) vs. money in bank accounts.
This is the most important subject, as obviously the market will generate a heavy demand for bank notes.
These bank notes are not subject to any negative interest rates.
As was discussed largely in the Swiss media, pension funds and the likes wanted to withdraw money from the
banks and store the cash in vaults. Costs for the storage of cash are distinctively lower than the negative rates at
-0.75%.
There are roughly only 65bln francs of banknotes in circulation. The excess demand of pension funds and the
likes wanting to store several billion in cash brought about special action from banks and the central bank.
Soon letters of banks circulated demanding not only 0.175% in cash delivery fees but also mentioning that
there is no guarantee the Swiss National Bank will actually deliver the cash and that the Swiss National Bank
will be informed of any movement and withdrawal including transparency as to who demands cash.
Deliveries of 1,000 franc banknotes have virtually stopped and getting bills with larger denominations has
become almost impossible should someone wish to withdraw in excess of 10m francs. It needs to be
mentioned here that one can still get cash at the cash machine. But it is only a matter of time when Switzerland
will run out of cash or prohibit cash altogether. Because public has not yet started, as individual bank accounts
with less than roughly 10m francs are still exempt from negative interest rates at most commercial banks.
Should the interest rate lower further there will also be negative interest rates on regular bank accounts. And
hence public demand for bills will spike.
5. Upward spikes in the interest rate for regular mortgages.
Most interesting anyways is the fact, that negative interest rates had the exact opposite effect on the rate of
interest for mortgages. Those have spiked since -0.75% in base rate are in effect. One would wonder how this
came about and there is a very simple – but at the same time frightening – explanation. Let’s assume the
following example: Bank A has a willing borrower for CHF 1mln at a rate of 1.50% for 10y (fixed mortgage).
At the same time Bank A has willing creditors, i.e. bank account holders, which it pays 0.00% overnight
(checking account). The bank is actually borrowing short to lend long.
Now as the bank is aware of the risk it might be in should overnight rates go to e.g. 5.00% again, it makes an
interest rate swap. The risk the bank might face is that if it had to pay its depositors 5.00% while only receiving
1.50% fixed for 10y, it would simply go out of business. Hence the interest rate swap: Bank A (1) sells the
income from the 10y fixed mortgage to Counterparty B and (2) in return receives the overnight deposit rate
from the Counterparty B. This makes sense in an environment of rising rates. As at an interest rate level of
5.00% overnight, the Counterparty B would pay to Bank A 5.00%. And Bank A would only have to pay 1.5%
to Counterparty B. But in the current situation the “interest rate hedge” costs the bank double: Bank A
currently pays 1.50% annually to Counterparty B. And now Counterparty B pays to Bank A the overnight rate.
As the overnight rate stands at -0.75% it is not Bank A receiving money, but additionally having to pay
Counterparty B. Hence Bank A pays 1.50% + 0.75%.
This drains the bank’s capital and thus reduces or eliminates the banks margin from its lending activities. Let’s
assume banks are now hedged for rising rates. But what if rates drop even further? Then the bank will have to
pay more and more money to the counterparty and the liquidation value of the 10y fixed interest rate swap
skyrockets. This will drain many banks of their equity – if rates drop further. And the chances that they will are
very high.
by Elihu » Tue Dec 08, 2015 8:17 pm 
