H/t Grant’s Almost Daily, an interesting (and alarming) nugget from the Financial Times from a week or so ago:
Data provider Bloomberg has urged users to switch the way they price US dollar interest rate options — in case they are caught out by a move by the Federal Reserve to push rates below zero.
In a note sent out across its terminals . . . the company recommended that customers review their computer models for calculating interest rate volatility — a key component in pricing options, which give holders a right to buy or sell an asset on a set date.
Bloomberg recommended that users switch to a new model “as a preventive measure” to ensure that pricing functions on interest rate options or similar derivatives continue to work in the event of negative rates. It is also making similar changes to its foreign exchange and commodities pricing models.
The recommendation comes as investors debate whether the US Federal Reserve will follow the European Central Bank and the Bank of Japan by cutting its main interest rate below zero for the first time, in an attempt to provide further stimulus to the economy. Such a move, which has the explicit support of US president Donald Trump, has been ruled out until now by Fed chair Jay Powell, who said last month that sub-zero rates are “probably not an appropriate or useful policy” in the US.
There is no “probably” about it. While interest rates at the moment are not exactly providing savers (including, of course, retirees) with a bonanza, negative rates, particularly if they are charged to ordinary savers (in Denmark, which has worked with negative rates for years, they are ‘only’ charged to larger bank depositors) and particularly if they are anything more than marginal, are likely to push savers into riskier investments, not something that pensioners should be looking at doing. And that is before we think about the broader message that they send: Thrift? Don’t bother . . .
And do they even work? I doubt they do, at least so far as the objective of encouraging companies to invest in their business is concerned.
Meanwhile, this, from The Conversation in January, is worth noting:
In practice, making rates negative has caused a problem in Switzerland — and much of what follows is true in Denmark as well. The banks know that if they went so far as to charge the average customer for depositing money, customers would simply withdraw en masse. This would wreck the whole banking business model by reducing working capital and causing severe funding problems. So the Swiss deposit rate for ordinary customers is now around a maximum of about 0.25%.
Banks have therefore had to absorb the charges they are paying themselves to deposit their own money with the central bank every day, where in times of positive interest rates they would be earning interest. Banks usually make money on the difference or “spread” between what they pay customers in interest for deposits or savings and what they charge in interest for loans. To minimise the damage to their profits, the retail banks have been unwilling to cut their lending rates to customers beyond a certain level — the average lending interest rate in Switzerland is at just over 2.6%, for instance.
So what the experiment has shown is that once the deposit rate reaches the lowest that banks are willing to go, a central bank can’t further reduce the base rate into negative territory to encourage cheaper lending. In other words, further reductions become ineffective at stimulating the economy.
The retail banks have had to live with reduced profits in this environment — despite performing relatively well under the circumstances. There is also pressure on the country’s pensions industry, since negative interest rates have also helped to turn bond yields negative, which affects how much they can pay to pensioners in benefits.
As a way of mitigating these difficulties, the banks and pension funds have sought riskier investments than usual for their spare capital. In particular, this has driven up the amount of money invested in real estate. Property prices have overheated, taking Switzerland to the brink of a housing crisis.
Great, just great.