Monday, February 15, 2016

Will Canada Adopt Negative Rates?

John Shmuel of the National Post reports, Canada could adopt negative interest rates within the next two years, Citi says:
Canada could be among a handful of countries to adopt negative interest rates in the next two years as the European policy experiment gains popularity, says a new report from Citigroup.

The Bank of Japan earlier this year became the fifth central bank to go negative, which means it charges financial institutions to deposit money with it. The idea behind negative rates is that they make it expensive to hold cash, forcing businesses, consumers and banks to start spending.

Citi economists, led by Ebrahim Rahbari, say in the report that Israel is likely to be the next bank to join the negative rate club this year, but Canada, along with a few others, could also introduce such a policy in the next two years.

“In the Czech Republic, Norway and perhaps Canada, a negative policy rate is not part of our central scenario, but the risk of a negative policy rate is material,” write Rahbari and his team in their report.

In the months after the financial crisis, many central banks in the developed world introduced zero interest rate policies, or ZIRP, in an effort to get consumers spending and investing by making borrowing cheap. Not doing so risked accelerating the crisis, as consumers would hoard cash, deflation would set in and aggregate demand would collapse, worsening a recession into a depression.

While zero rates helped return growth to the developed world, some economies have not had stellar results. Deflationary pressures still dog many European economies and growth remains anemic. Disappointing growth led the European Central Bank to adopt negative rates in 2014.

In a way, a negative interest rate is an act of desperation. It punishes savers and rewards risk taking by making borrowing cheap — theoretically, banks could charge money on savings deposits and even return money on loans.

In Europe, interest rates are already going further into negative territory. Sweden’s Riksbank announced Thursday that it is lowering its repo rate from -0.35 per cent to -0.5 per cent. Negative rates have made borrowing for consumers essentially cost-free, while driving down the value of the Swedish krona immensely.

Unfortunately, while the central bank cut rates further, its policymakers have also pressured the Swedish government to introduce new regulations to cool Sweden’s ultra-hot housing market, which Riksbank officials bluntly label a bubble.

Because negative interest rates are uncharted monetary territory, there is still little data about how effective they will be long-term. What Citi does note is that as more central banks deploy them, global monetary becomes a “zero-sum” game.

“The more conventional and common negative policy rates become and, given how pervasive low inflation and weak demand are across countries, the more likely it is that a negative rate in one country will be followed by cuts elsewhere,” write Rahbari and his team in their report.

For Canada, Citi notes that there are still policy options in place before the central bank has to resort to negative rates. The federal government is set to unveil billions in new stimulus spending to prop up the economy. As well, the bank could reintroduce forward guidance, first utilized by former governor Mark Carney in 2009.

Citi notes that until very recently, it was inconceivable that central banks such as the Bank of Canada would even consider negative interest rates. But a continual undershoot of inflation targets, stubbornly weak growth in gross domestic products and a lack of alternate policy options leaves central banks around the world with few alternatives.

“Should these not suffice, the BoC is likely to consider some combination of asset purchases and negative policy rates in due course,” write Rahbari and his team in their note.
I've already covered the rising prospect of negative interest rates in Canada. This is all part of the new negative normal and why rates around the world will remain ultra low for years as central banks ultimately lose the titanic battle over deflation.

Interestingly, negative interest rate policy is being criticized by right-wing media outlets like the Wall Street Journal which published an op-ed by former St-Louis Fed president William Poole calling it a dead end and by left-wing media outlets which think negative rates are aimed at driving small banks out of business and eliminating cash.

In my opinion, both are wrong. Desperate times call for desperate measures and central banks are desperate because so far, they've been the only game in town and they know there's little they can do to prevent the deflation tsunami hitting the global economy.

In Canada, the new federal government is gearing up to introduce expansionary fiscal policy in the form of infrastructure spending, and it's enlisting the help of Canada's Top Ten pensions.

But infrastructure projects take time to seep through the real economy and the crisis in Canada will be deeper and last longer than most economists are forecasting right now. All this to say that depending how bad things get in the global economy, we can't discount negative rates coming to Canada.

The Bank of Canada stayed put at its last policy meeting most likely because of the sharp decline in the loonie prior to that meeting but that doesn't mean it won't cut at its next meeting. In his latest comment, The Bond Market is Talking: Is the Bank of Canada Listening?, Ted Carmichael notes the following:
The bond market is telling quite a different story from the one used by the BoC to justify remaining on hold on January 20.

The decision by the BoC to stand pat contributed to the recent appreciation of the Canadian dollar while the oil price and the terms of trade have weakened further, inflation expectations have taken another sharp step down, the yield curve has flattened indicating weaker expected real GDP growth, and corporate spreads have widened pointing to tighter financial conditions.

These developments point out the potential costs of waiting for the federal budget, which is unlikely to bring any major surprises for the markets. The BoC would likely have preferred not to have to deal with a further drop in oil prices, financial market turmoil, and shifting foreign central bank policies. However, they are now a part of the macro environment that the BoC must take into account as it decides whether to stand pat again on March 9.
I urge you to read his entire comment carefully as I agree with him, the bond market is painting a much more ominous picture of the true state of the Canadian economy and the Bank of Canada better be listening to it and act accordingly at its next meeting on March 9th.

Lastly,  Marc Chandler, the head of foreign exchange markets strategy at BBH, told CNBC on Friday that the Bank of Canada is the most likely of the major central banks to opt for negative rates this year or next:
"I am not saying the Bank of Canada will, but that is the most likely candidate of those that are not there yet… I do not see this as anything but very low risk in the U.S.," he said.

Canada's targeted overnight rate is already low, at 0.5 percent, and the Bank of Canada has prepared markets for the possibility of negative rates by discussing how they might work as a policy tool.

It said in December that the lower bound for the policy interest rate was around minus-0.5 percent.

"In the unlikely event that the economy was hit with another major negative shock, the Bank could implement unconventional monetary policy measures. These include forward guidance on the future path of its policy rate, stimulating the economy through large-scale asset purchases (commonly referred to as quantitative easing), funding to ensure that credit is available to key economic sectors and moving its policy rate below zero to encourage spending," the bank said in a statement.
We shall see what happens next. I think if financial markets calm down, it will give central banks some breathing room, but unless we get major reflation, I wouldn't discount negative rates coming to Canada and even the United States where the bond market is facing off with Janet Yellen over this prospect.

Below, after Federal Reserve Chair Janet Yellen's testimony to Congress, New York Fed president, Bill Dudley, believes negative interest rates should not be considered for the U.S. economy, reports CNBC's Steve Liesman.

The New York Fed president can say whatever he wants, what ultimately matters is what the bond market is saying. And if the bond market prices in negative rates in Canada and the U.S., I wouldn't bet against it.

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