Morning Brief – Positively not negative

Positively not negative

In a press conference yesterday Jay Powell distanced himself and his central Bank from the possibility of negative interest rates. It might sound a little dry and with hundreds of thousands of people having already lost their lives to Coronavirus, a little misplaced. However, to the foreign exchange market this news and yesterday’s press conference in general, is of great importance.

The chairman of the US Federal Reserve distanced himself from allowing the US economy to embark upon a phase of negative interest rates. For years the concept baffled economists with textbooks claiming a “0 lower bound” which spoke of the undeniable impotence of monetary policy when interest rates were already too low. Over the last decade since the Eurozone has credibly stuck to negative rates, it’s become more widely accepted as possible but even more contentious.

If we think about it, negative rates mean that borrowers get paid to take out money and savers get charged to hold money. Logically, the move to negative from low rates continues to discourage saving and promote spending and consumption to revitalise an economy. Great, it works then! The problems arise in two areas: 1) we create a borrowing/saving paradox 2) we hurt the financial sector. Negative interest rates have the ability to unsettle a consumer and investor base. Therefore, even though they are in effect being paid to borrow money there is an aversion to borrowing and taking on additional debt during times of economic distress marked by the novel change of sign in interest rates. The financial sector too is harmed as it struggles to externalise the cost of saving onto its clients. Negative rates on deposit accounts are hard to implement for fear of clients switching banks. The Mexican standoff is hard to win because if you win the standoff you lose money and if you bail out early, you lose even more.

Because of these concerns and particularly the impact upon the United States’ developed financial sector, Jay Powell socially distanced himself to the nth degree from negative rates yesterday.

The implication of negative rates in the foreign exchange market is twofold. Firstly, for the market to take a commercial or speculative position in favour of your currency they’re going to pay a pretty penny to do so if your rates are negative. Forward, swap and futures prices will all become skewed against the negative yielding currency making it more expensive to buy – it will naturally fall in its spot price to compensate for this lack of appetite. Secondly, it becomes a prime candidate to be a funding currency to buy higher yielding currencies. As rates turn negative the disparity between domestic returns and international higher yielding currencies widens dramatically encouraging speculative positions against your currency in good times.

In distancing the US economy from this state of affairs and potentially Dollar negative monetary policy, the market priced out some risk from the greenback. It rallied strongly following Powell’s conference. The chairman also offered an even more bleak outlook to the economy with reference Coronavirus as comments on stock market overvaluation gathered pace in the wider market. The result was another risk off day with emerging markets back on the defensive and the Dollar surging against the Euro and Pound.

Discussion and Analysis by Charles Porter

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