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Negative rates: central banks play with fire

Following hard on the heels of Japan’s move into negative territory, the Riksbank decision underlines the increasing gap between the comfort central banks now seem to have below the zero-bound and the growing sense of discomfort on display in markets.

Eoin Murray head of the Hermes investment office says the market has been struggling to digest the increasing divergence in central bank policy for some time now.

“There is a growing feeling that the whole world could end up like Japan,” he told Portfolio Adviser, adding, “markets have been somewhat overtaken by a rush of negative sentiment that has been exacerbated by the use of systematic strategies.”

Scott Mather, CIO for US core strategies at Pimco said in a note out on Thursday, central bank advocates increasingly characterise negative interest rate policy as “nothing more than an extension of conventional monetary policy”.

But, while he admits it is difficult to know the counterfactual argument given the unprecedented nature of the situation, he says it appears that negative interest rate policy hasn’t actually been very effective at lifting expectations of future growth and inflation.

“Instead,” he said, “it seems that financial markets increasingly view these experimental moves as desperate and consequently damaging to financial and economic stability.”

And this is where the problem lies. Where before a central bank’s decision to drop rates was seen as automatically stimulative, this no longer seems the case. And the further down the path of negative rates they go, the increasingly desparate they begin to appear.

Currency wars

Rate cuts are still very effective in at least one respect though. When the Riksbank lowered its main interest rate by 15 basis points to a record low of -0.5% yesterday, the Swedish krona dropped to its lowest point versus the euro since August.

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Jarl Åkerlund, a portfolio construction expert at Swedish bank Nordea, believes one of the motives behind the Riksbank’s negative interest rate policy is to weaken the currency. “Sweden is a big exporter, so when competitors like Japan and the eurozone pursue QE policies, you also have to do something to weaken your currency. Otherwise, our export industry would have a problem,” he said.  

But otherwise, as Mark Wharrier, co-manager of the BlackRock UK Income Fund points out, the relationship between central bank interest rate and policy effectiveness has started to fade.

Between the financial crisis and October last year, a worsening in economic conditions has tended to lift markets as investors anticipated monetary stimulus. But, said Wharrier: “The link started to waver when the Federal Reserve deferred increasing interest rate rises in October last year; the market let it be known that it would have preferred the central bank to take action. It has now become clear that – for the UK at least – that link is decisively broken.

“Earlier in January, Mark Carney ruled out any imminent rise in interest rates, swiftly dispelling any lingering expectations that rates might rise in the near-term… Carney appears unequivocally to be supporting a ‘lower for longer’ interest rate environment. In the past, this would have pleased market participants, who would have welcomed another phase of loose monetary policy, but now it seems bad news really is just bad news.”

Part of the problem is that while growth in many areas has begun to pick up somewhat, it has remained rickety and, more importantly, inflation has remained stubbornly low, despite the ocean of liquidity slowly pooling within the financial system. The collapse of commodities hasn’t helped the situation, nor has the growing likelihood that China is going to have to devalue its currency.

All of this has led to the creeping sensation that while central banks may well be prepared to do whatever it takes, it may not be enough. A point Alex Sebastian argued well at the time of Japan’s jump into negative territory.

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Part of the Mark Allen Group.