The new negative normal

May 29, 2016 09:00 AM

As the 1980-era adoption of supply side economics was supplanted in favor of Keynesian stimulus following the 2008-09 crisis, interest rates in 10 nations experienced a negative rate of change of 24.94%, with the downward trajectory continuing to present day. Viewed from 2014-15, the negative rate of change was approximately 40% of the 2008-09 depreciation and -8.58% year-over-year. The year 2008 was a turning point. The policy choice dilemma was stimulus or adjust for the future. 

As such, a regressive stimulus policy was chosen. With the end of Bretton Woods and the new era of free floating currencies in1971-72 as the starting point, there are four quadrants, each quadrant being 12.5 years. The year 2008 was the demarcation line of the third and fourth quadrants. Stimulus policy expedited markets into the final period.

Since 1694, when the Bank of England was established as the world’s first central bank--followed by Scotland in 1695--it has been customary for central banks to adopt questionable fourth-quadrant policies when a new market period highlighted by prosperity reigns.

Sir Isaac Newton began cycles and quadrants when, as Chancellor of the Exchequer, he overvalued gold in relation to silver in 1717. Subsequent 50-year market periods 1770-1820, 1820-1870, 1870-1920 and the current gold wars that began just prior to the 1971 closing of the gold window were based on gold’s fixed valuations.

The reason fourth-quadrant policies are generally questionable is because of traditional second-quadrant market crashes. New policy prescriptions are implemented in fourth quadrants because third-quadrant corrections end, following the fallout from the second-quadrant crashes. 

Analyzing rates

A 10 supra-national simple interest rate index was constructed not only to analyze the current economic context, but to explore the interest rate situation, particularly as it relates to the five negative interest rate nations.

The 10-nation supra-national index includes Switzerland, Europe, Japan, Sweden, Norway, the United States, the United Kingdom, New Zealand, Australia and Canada. Interest rates include Saron (Switzerland), Eonia (Europe), OCR (New Zealand), OCR (Australia), call rates (Japan), Stibor (Sweden), NOWA (Norway), Fed Funds (United States), Sonia (United Kingdom) and Corra (Canada).

Negative interest rate nation Denmark was slated as the 11th cohort, but the Denmark central bank, in cooperation with the Danish Bankers Association, is in transition to transfer Tom/Next data responsibilities to Nasdaq OMX. Current data, rather than historical, is difficult to obtain. The negative interest rate supra-nationals Switzerland, Europe, Japan and Sweden were included.

Monthly data were aggregated from January 2007 through January 2015 for each index component and calculated as simple moving averages recorded in successive order from one to nine years for each nation, for a total of 90 moving averages. Data points total 1,080,108 monthly averages for each nation. As a simple index, the year 2007 was the base year for viewing 2008-2015. Overnight interest rates constitute the commonality among index component interest rates (see “Global meltdown,” below). 

As many nations abandoned Libor fix participation, central banks began a long arduous process of reviewing national commonalities to revamp overnight rates. Traditional overnight rates were set low to balance both end-of-day bank surpluses and deficits, but also to gain a competitive advantage in other nations’ markets.

Overnight rates were used because of disjunctions between and among nations in specific markets. The United Kingdom and the United States, for example, lack a 60-day maturity relationship, while New Zealand and Australia are void in the one-year maturity connection. The most important consideration for revamping overnight rates was to re-establish corridor systems inside respective national markets, as well as between and among nations.

Interest rate corridors are reflections of monetary policy. The European Central Bank interest rate corridor from Eonia to the refinance rate was traditionally set at 75 basis points post 2008, and 100 basis points since the euro introduction. Because of four Eonia reductions from June 2014 to the present, the corridor is now 60 basis points.

Further current corridors are: United States, from Fed Funds to headline is 14 basis points, and from Eonia to Fed Funds is 77 basis points. Japan to Europe is measured at 30 basis points, and 47 basis points with respect to the Fed Funds rate. Australia and New Zealand share a 25-basis-point relationship, and 77 and 88 basis points with respect to the Fed Funds rate. Swiss to Europe allocates 30 basis points, 30 basis points to Sweden, 20 basis points to Canada and 1.07 to the Fed Funds. The United Kingdom to Europe corridor is 80 basis points and nine basis points to the Fed Funds. 

Not only did interest rates peak in 2007, but corridor compression is the result of adoption of Silvio Gesell’s first time implementation of negative interest rate experiments.

Policy shift

Based on Gesell’s 1906 “Natural Economic Order” and his 1891 “Reformation of Coinage as a Bridge to the Social State,” central bank policy delineates three goals: Stop the rate of interest growth, control money velocity and stop exchange-rate appreciation.

Money velocity is key, especially as money is directed inside small corridors. If money supply velocity is measured as gross domestic product (GDP) divided by monies in circulation, then the object of money circulation is to channel money inside smaller corridors. Economically, velocity equalizes goods and money relationships to determine prices and stabilize purchasing power. Money is stagnated by rates of interest growth, and if removed GDP would rise quickly to the point negative interest would be justified. Gesell views interest rates in reverse order as prices drive interest rates rather than movement in money supplies.

A further policy to ensure money direction inside corridors is to eliminate interest rate maturities and then connect remainder interest rate categories to an interest rate fix based on volume. The ECB offered 15 maturities upon euro introduction and then eight in 2013. Five maturities will be offered July 1. The Federal Reserve has adopted volume-weighted medians. Consolidated maturities allow future interest rate rises and reductions to normalize expeditiously. The ECB, for example, normalizes many months post-rate rises or falls, while New Zealand and Australia normalize within days. The downside to consolidated maturities and volume fixes is less ability to control and slow volatility. 

As 2008-09 experienced negative rates of change year-over-year, overnight rates continued a slower rate of change decline until 2014-15. The ECB was the first in June 2014 to slash the Eonia to zero and then entered negative territory on September 2014, followed by the Swiss in December 2014 and Sweden in 2015. Canada reduced Corra on January 2015, while New Zealand dropped OCR from 8.25% in January to its current 2.25%. While rates of change slowed from 2008 to 2014, actual year-over-year changes maintained a steady rate of decrease, as 2012-15 saw a -30.23% collectively, yet the full contraction began aggressively again in 2011.

The index mean of the 2007 base period was 1.7109, and it was consistent as measured against forward rates year-over-year, although seven-year rates calculated six years forward at 1.9762 lack synchronicity to the remaining yearly maturities. Correct forward curves are smooth to allow trades between rates. An out-of-sync maturity alters curve dynamics. Descending forward rate lines are a major hurdle to overcome if interest rates ever change course and rise. In volatile and uncertain interest rate markets, it becomes harder to pinpoint the correct tradeable maturity to lock in forward rates for future dates. Hedges must adjust constantly. 

Carry trade implications

The carry trade measured from the high-to-low mean index values and calculated in terms of foreign exchange pips reveals that 10,860 pips were lost since 2007 (see “10-Nation Simple Index,” below). There were 7,279 since 2008, while remaining under the current 11,679 mid-point. The index began in 2007 at 17,109 pips and ended January 2015 at 6,249. In actual yearly pips lost, 2015 experienced the sharpest decline at 1,080. In 44 years of currency trading since the January 1972 free float in monthly averages, 18 years had 1,000-pip or more losses years, and 10 years experienced 1,500 pips or more. Falling interest and exchange rates lend uncertainty to carry trades as a steady source of income, currency value appreciation and yield gain, and analyzing this data can provide some clarity to the process.

Aggregate weights were calculated year-over-year to confirm the division between the six- and seven-year maturities and also to confirm the downslope year-over-year. Aggregate weights rarely hold enormous tradable revelations; however, weights provide insights to positions and possible adjustments as the simple index is oversold, while aggregate weights lean toward overbought. This suggests that we’ll see at least a slower rate of change, as aggregate weights were calculated to be 1.2349 for 2015. 

Among the five negative interest rate nations, the Swiss Saron is negative with respect to the seven-year average, while Eonia is negative with respect to the three-year average. The Stibor is negative at the one-year average, while Norway and Japan remain positive from one through nine years. Denmark’s Tom/Next rates, based on compiled data, are negative with respect to the four- to five-year average.

Negative trends

As quantitative easing met Keynesian liquidity traps when interest rates attained zero and the intended economic effects failed to materialize, negative interest adoption was the next step. This is a break of the positive zero point when ranges encompassed 0.0 to 1.0. While zero is the bottom, negative zero represents a catastrophic collapse for a simple reason: Money achieves a negative value. As ranges, Sweden and the ECB remain middle bound while Japan and Norway are at the top of the range. Denmark and Switzerland are located at bottom ranges.

The crisis and precipitous drop in 2008-09 offered downside trend momentum. Central banks not only adopted Gesell’s negative interest rate theories but followed Gesell explicitly in terms of exchange rate depreciation, slow interest rate growth and channeled money velocities. The current period represents the implementation of these policies. The question for the future is whether central banks will revert to supply side policies by manipulating the daily money supply once interest rates bottom and reverse course. 

Of course, embedded in this question is the assumption that the current negative interest rate policy will prove successful. Negative interest rates are not only here to stay for the foreseeable future, but until inflation targets are achieved, more central banks are expected to adopt them to remain competitive. Norway, Bulgaria, Czech Republic and Israel are possible candidates.

About the Author

Brian Twomey is an independent trader and author of “Inside the Currency Market: Mechanics, Valuation and Strategies.”