Negative Interest Rates and the Currency War

There have been some noteworthy developments on interest rates over the past week. The ECB's cut of its deposit rate to zero has pushed some short-term market rates below zero. France sold bills earlier this week with a negative yield. Denmark cut its key two-week CD rate to -20 bp. The Swiss yield curve out 5 year is below 0 (the 2-year yields -0.39%, for example, and the 5-year yield is now -0.01%).

Some observers have suggested this is a new front in the currency wars. While recognizing the competition between countries, this formulation seems to be an over-generalization. There seems to be at least three different reasons that have driven rates so low. First, some countries are contracting or suffering weak growth. This was the key factor behind the ECB's rate cut.

Second, addressing weak growth is are not only function of policy. Funds have flowed into Denmark and Switzerland, not because the economies are booming or because their asset markets. Rather investors fleeing the European debt crisis and fearing a redenomination risk have shifted their savings out of the euro area. This shift in savings can drive down interest rates and this seems to be the case in the Swiss curve. The fact that Denmark's 10-year bond yield is just above 1% is not a function of the 2-week CD rate. Back on June 1, Denmark's 10-year bond was yielding 0.95%.

Third, low rates may also be a function of deflationary pressure. This seems to be the main factor behind the near zero interest rate policy of the Bank of Japan. As Japanese officials recently point out, in inflation adjusted terms, and on a GDP per capita basis, Japan's economy has outperformed within the G10. It is true that the MOF ordered record intervention to step the appreciation of the yen last year, and the yen's strength is a factor behind Japan's deflation. The near zero interest rate policy has been ineffective in combating the yen's strength and does not seem to be the primary goal of the policy.

There are intended and unintended consequences of policy makers decisions. Some of the unintended consequences may be foreseeable. Typically central banks want to see their currency move in the same direction as monetary policy. When a central bank is in an easing mode, currency appreciation can blunt or offset the easing of monetary policy.

However, this need not be the same thing as cutting interest rates to drive a currency lower. Intentions matter. The ECB cut its refi rate by 25 bp and lowered the corridor that its trades within by 25 bp as well. This brought the deposit rate to zero. Its goal was to provide more monetary stimulus to the regional economy. A depreciation of the euro was not the goal but a foreseeable and arguably not completely undesirable consequence.

At the same time, sterling has generally been firm despite the BOE's decision to expand quantitative easing. Sterling has traded at 4-year highs against the euro as recently as yesterday. It has appreciated by about 4.4% this year on a broad trade weighted measure since the start of the year. It has appreciated a little more than 1% on this metric since the BOE decided to renew its gilt purchases in earlier this month.

Currency war is strong rhetoric and a broad brush to characterize what is happening. The rhetoric does not draw a distinction between currencies that are under-valued and those that are over-valued. For example, according to the OECD, the Swiss franc is more than 34% over-valued and the yen is more than 25% under-valued. This is quite different that the under-valuation of many emerging market currencies. The IMF/OECD estimates that the Brazilian real is 12% under-valued; the Chinese yuan 54% under-valued and the Indian rupee is more than 188% under-valued.

Lastly, the currency war framework would seem to suggest sharply divergent currency moves as countries press their advantage. Yet, looking at the G10 currencies, the range between the best performer and worst performer in H1 12 was about 6.7%. In H1 11, the range was close to 10.5%.

In summary, there are several reasons why countries reduce their interest rates to near zero and why some market rates are below zero. The risk is that those same considerations, which include poor growth prospects, deflation pressures and attempts to neutralize safe haven demand, drive other countries to reduce interest rates. The global de-leveraging phase and attempts to put fiscal policy on more solid footing warns that these considerations will likely persist.