Sunday, June 19, 2016

What the Bond Market is Telling Investors

Guest post by Norman Mogil

Over the past month, the global bond markets have been sending out signals that all is not well with the global economies. Initially, the surge in negative nominal rates in Europe and Japan rattled many investors in both the fixed income and equities markets. This historic development suggests that large-scale investors are anticipating low growth and disinflation for many more years. Simultaneously,  the yield curve, especially in the US, has been flattening, again signalling that growth is slowing, giving the policy makers considerable  pause in their deliberations on the course of future interest rates. This blog examines both these developments to help the reader understand the signals coming out of the bond markets around the world.

Nominal and Real Rates of Interest

For more than a year, short to medium term rates of interest in many countries have landed in negative territory. The ECB instituted negative overnight lending rates in an effort to discourage commercial banks from depositing excess reserves with the ECB; instead, these such funds should be made available to their borrowers in the hope of stimulating loan demand throughout the region. More recently, the ECB started to buy, initially, longer dated sovereign debt from member countries in the expectation that long-term rates would fall to stimulate investment growth. Now, the ECB has expanded this quantitative easing program to include investment grade corporate bonds. Purchases of both types of debt exceed 80 billion euros a month, as the ECB pulls out all stops in pursuing its goal of re-inflating the EU economies. The result of this combined effort is shown in Table 1 which reveals that major  European countries and Japan now live under a regime of negative long-term rates.

Of more significance is the measure of real rates of interest--- nominal rates minus the rate of inflation. In some countries, real rates have turned negative ( e.g. Japan, Switzerland, and Canada) and in other countries, the real rates are barely in positive territory ( e.g. Germany and France). The key takeaway from Table 1 is that the industrialized nations now offer 10-year bonds at real rates that are less than 1 percent, well below the long term  historic rate of 2 percent.

Flattening Yield Curve   

The yield curve represents what investors are willing to accept by holding debt over short, intermediate and long-term periods. A typical yield curve is sloping upwards since longer term investors normally require a greater return to compensate for the risks of holding debt over many years. The extra return - referred to as the term premium - reflects the investor's view of future economic growth and inflation among other considerations.  A rising term premium reflects concerns over excess supply of debt, credit quality, and higher inflation in the future; a falling term premium has these factors moving in the other direction.  Over the past year or more, the term premium has fallen significantly, hence the fall in long-term rates.

Changes in the slope of the yield curve signify changes in the economic outlook. Over the past few months, the yields on long-dated US Treasuries, 10 years and up, have fallen and, at the same time short term rates have moved up. ( see  Chart 1)  These two developments are related. Short rates have moved up  in anticipation of the Fed increasing its overnight interest rate. Fed Chairperson, Janet Yellen, has spoken of the need to increase the policy rate in " the coming months" and other members of her committee have voiced similar views. In its most recent policy meeting, the FOMC continues to hold out the possibility for at least one or more rate increases before year's end.  At the same time, investors in the long end of the bond market are saying that any short rate increases will have a detrimental effect on economic growth and that any policy shift must weigh that consideration. In effect, the long end of the curve is saying: increase short rates at your ( Fed`s)  peril.

Chart 2 maps out the change in the spread between 2- 10-year yield. It has narrowed from 170 bps to 90 bps over the past year. In part, the 2-year rate moved up sharply in response to the Fed signalling that it wants the bank rate to move up this year as part of its objective to “ normalize” rates. But it is the falling long-term yields which are most disconcerting. It signifies that the investors expect future growth to be weaker and that they also expect future inflation to be lower than was previously forecasted a year earlier ( Chart 1). It is the change in expectations that we need to focus upon.

Changing Expectations 

There has been a dramatic shift in the way consumers' view future inflation.  The University of Michigan surveys reveal that there has been a persistent decline in the expected rate of inflation over the next  5- 10 years (Chart 3). In the 1990s, consumers expect annual inflation to exceed 4 percent; by 2010-15,  consumers' expectations have dropped down to well under 3 percent. In its most recent survey, U of M discovered that consumers expect inflation to average just 2.3 percent for the next 5 years

Investors have also adjusted their inflation expectations. One measure of inflation expectation is the 5-year breakeven inflation rate. This is the difference between the 5-Year Treasury bond rate and the yield on an inflation-protected security with 5-years remaining to maturity ( so-called TIPS). Chart 4 shows how these expectations have dropped considerably from around 2.8 percent in 2012 to 1.6 percent today.  In fact, investors have adopted a greater downward revision to their expectations than in the case of consumer groups. It is the investors who are driving the bus on the yield curve road.

Other Factors Affecting Long-term Bond Yields.

 Ben Bernanke has maintained for some time that the global savings rate is too high and that excess savings is fuelling the demand for debt instruments, especially quality sovereign debt. There is a lot of merit in this argument when one looks at the high savings rates in the emerging markets - often in excess of 25 percent of GDP. Even in the industrialized countries savings are relatively high. Or, alternatively, consumption is too low. Either way, excess loanable funds have to be channeled into investment, and this generates a growing demand for credit instruments worldwide.

Another explanation for the fall in  long-term rates is related to liquidity in the international bond markets. Barry Eichengreen  argues that ``international liquidity has plummeted from nearly 60 percent  of global GDP in 2009 to barely 30 percent today.` The most important form of bond liquidity is the US government bonds which are held by banks, large institutions, and foreign central governments. Recent auctions for US Treasuries feature large oversubscriptions, and this has driven yields lower. There is more than just a temporary flight to safety to quality debt; there appears to be a major shift in asset preference in favour of high-quality debt issued by the US, Germany, Japan,  and  UK governments . To the extent that new government debt issued is immediately taken up by these institutions and are essentially held to maturity rather than traded, means that there is less liquidity in the marketplace. Scarcity will drive up bond prices.

What can we learn from the recent behaviour of the yield curve? 

Low yields are a symptom of  economic malaise . Although there have been many criticisms of central bankers for introducing negative short interest rates, the central bankers are not responsible for the decline in long-term interest rates. Negative interest rates are not the problem. Slow growth and disinflation are driving longer rates to historic low levels. These bond yields are not the problem but are the symptom of widespread economic weakness that is not expected to improve over the next decade.

Low inflationary expectations are well-entrenched. Clearly, the negative nominal and real rates of interest are sending a powerful signal that those economies are going to experience very low growth without inflation for the next 5 to 10 years. There is a well-entrenched view that inflation and growth will remain very subdued over the next decade.

Shortage of quality debt.There is growing evidence that quality debt remains in strong demand and highly sought-after. The decline in the term premium on long-dated government bonds demanded by institutional and central bank investors supports this assertion.

Long term rates to remain low. The combination of strong demand and supply restraints will keep long bond yields at these levels or even lower for many years. Any change in the current direction of bond yields will not come from within the market itself. Rather yields will rise only if governments resort to aggressive fiscal policies that promote growth and higher inflation. As yet, there is no sign of any policy shift in that direction, especially in the US and the EU.


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Unconventional Policies and Their Effects on Financial Markets

Guest post by $hane Obata


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Tuesday, June 7, 2016

The fall in commodity prices hits the Canadian banks

Guest post by Norman Mogil

With the release of Canadian banks’ second-quarter results, investors are beginning to measure the impact of the oil price collapse on the domestic financial industry. Widespread are the write-downs and other provisions the banks are taking in response to the weakened credit quality of many clients in the oil patch. This blog looks at this issue and its implications for future bank stock performance.

On the whole, the Canadian banks turned in a profitable second quarter, although in some instances profits declined ( e.g. Scotiabank and BMO Montreal). The banking sector continues to show respectable results in its retail and consumer loan divisions. Also, their mortgage portfolio remains healthy, supported, to a great measure, by good loan-to-value measures and mortgage insurance. Finally, the banks’ capital ratios meet international standards as the they continue to improve in this area. Where the banks face the biggest challenge is with their loans to the energy and commodity sectors in Canada and the United States.

Provisions for Loan Losses (PCL). Chart 1 measures the loan losses for the major Canadian banks in terms of a percentage of the average loans outstanding. PCLs represent loans that have been written down for non-performance. There has been a dramatic increase since 2015 Q4 results as the slump in the oil prices take its toll.

Gross  Impairment of Loans (GILs). Another way to look at the impact of the oil sector is to examine the increase in GILs. GILs are loans that are non-performing loans that a bank will have to either write off or sell at a discount to a debt collector who will likely seize the collateral. Either way, bank profits will be negatively impacted. Chart 2 graphs the substantial increase over the past 12 months in GILs, especially Canada’s largest domestic bank, RBC.

Chart 3 demonstrates the combined effects of both PCLs and GILs. RBC attributes the increases in both ratios to the sustained low oil price environment. Furthermore, these ratios could well deteriorate further the longer oil prices remain around these levels.

The banking industry is most exposed to the highest risk segment of the energy sector. Fully 82 percent of RBCs energy sector loans go to exploration, production and drilling activities; loans to the integrated and refining segments remains relatively small. And, geographically, the bank’s exposure is roughly split evenly between Canada and the United States.

Capital Market  Revenues(CMRs). CMRs are closely related to the commodity sector performance. The banks generate a significant proportion of total revenues from such activities as M&A, trading in equity and fixed incomes, IPOs,  and advisory services, all of which have suffered declines over the past few years.( Chart 5). Moreover, this segment of the industry has come under heavy regulatory scrutiny, adding to the cost of operations at a time when revenues are declining.  Where CMRs used to generate between 15- 20 percent of total bank revenues, this activity now generates about between 11-16 percent, more importantly, the trend has been steadily declining as the industry grapples with a weak investment environment and rising costs.

The Outlook. The Canadian banks continue to perform reasonably well as their core segments--- retail and mortgage markets--- hold up well. Nevertheless, they face considerable headwinds as Canada contends with weak oil and commodity prices and declining business investment. ( Recent surveys by Statistics Canada point to continued declines in additions to  capital stock. The Bank of Canada anticipates that this erosion in business investment will contribute to a lower potential GDP growth and that , in turn, will impact future wage and profit growth--- both of which will be felt by the banks going forward.


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Monday, June 6, 2016

US labor markets take a turn for the worse

Friday's US payrolls report, which to a large extent represents a latent effect of the US dollar rally over the past couple of years, was dismal. On a relative basis, hiring Americans has become more expensive for global firms. An elevated level of uncertainty, driven in part by risks associated with the US monetary policy as well as the presidential elections, has not helped.

Let's look at some trends in the labor markets.

1. The job market's weakness has now spread to the services sector.

Source: BofAML

2. After a strong showing over a previous couple of months, US labor force participation has turned lower.

3. Even as the headline unemployment rate (U-3) declined to lows not seen since 2007, a broader measure of unemployment, which includes marginally attached workers plus those employed part-time for economic reasons (U-6), has stalled.

Below is the ratio of the headline jobless rate to the broad (U-6) unemployment over the past couple of decades. While fewer people are filing for unemployment benefits, the health of the broader labor market has significant room for improvement.

 4. Related to the above, here is part-time employment for "economic reasons".

5. US manufacturing jobs growth has worsened again on a year-over-year basis.

6. Wage growth is back below 2.5% (YoY). Unless the non-demographic component of labor force participation begins to climb again, it's difficult to see a significant jump in hourly earnings growth. It is worth pointing out, however, that given slow inflation, real wage growth in the US is reasonable relative to a number of other developed economies.

7. The next chart shows the average weekly hours worked by US employees on a year-over-year basis. Even with a positive hourly wage growth (above), declining hours could mean less cash in households' pockets.

8. For what it's worth, the headline unemployment rate is now below the 'Natural Rate of Unemployment". According to classical economic theory, inflation should begin to rise at this point. But given some of the labor market challenges shown above, price increases - outside the recent increase in energy and agricultural commodities - should remain benign.

Separately, the ISM Services PMI weakened in May. This provides more evidence that the soft patch in the US economy is not limited to manufacturing and energy.

The ISM Non-manufacturing Employment Index is consistent with Friday's poor payrolls report (above). The ISM services sector new orders index is also shown. Is this consistent with the projected 2.5%-3.0% US GDP growth in Q2?

In response to the weak jobs report (and to some extent the ISM Non-manufacturing PMI) the June rate hike is off the table according to the futures market. The July contract rose above the pre-Fed-minutes levels (it was the Fed minutes that temporarily resurrected the chances of the Fed doing something in June.)

Here is what Friday's economic reports did to the implied rate hike expectations in 2016. Another weak jobs report will send the probability of "no hikes" to 100%.


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Sunday, June 5, 2016

The Decline in Canadian Business Investment

Guest post by Norman Mogil

Business Investment  “depends on the prospective yield of capital, and not merely on its current yield” , John Maynard Keynes

One of the many puzzles of the recovery since the 2008 crisis has been the corporate sector’s reluctance to add to a nation’s capital stock. Investment in new plant and equipment along with the construction of new productive facilities has lagged behind the experience of previous recoveries. Throughout the industrialized world, the rate of growth in fixed capital investment has been dismal, resulting in below average rates of growth in national income. The decline in business investment has been quite dramatic. In North America business fixed capital investment is running 20 percent lower that recorded in 2007. (See Chart 1)

Source: BIS

This dramatic weakness in capital formation is worrisome given all the factors that one would expect would generate a flourish in capital expenditures. Central banks have implemented unprecedented monetary stimuli in the form of zero interest rate and quantitative easing, contributing to the dramatic fall in long-term interest rates. Corporate profit margins are at historic high, and retained earnings continue to grow. And, equity prices remain quite elevated--- all these developments should provide the corporate sector with the enthusiasm to undertake capital investments. Yet, that sector continues to display weakness, contributing to what the IMF characterizes as the`` new mediocre`` growth performance. What lies behind the failure of business investment to expand?

The Decline in Corporate Profits  

The first clue to this answer lies with the slump in corporate profits and corporate profitability. Chart 2.1 and 2.2  shows the significant fall-off in the level of corporate profits in the United States and Canada over the past two years. The principal reason for this decline is the failure for the revenue to grow. Profits would have been even weaker had wage growth not been contained.

The Canadian Experience

The Canadian experience exemplifies what lies behind this profit weakness. If we look at the rates of return on equity and on capital employed, we see that there has been a steady decline in returns to investment for all industries and in particular for non-financial industries. (See Chart 3). Whereas the Canadian non-financial companies return on total capital employed registered  6.7 percent in 2104, by the first quarter of 2016 these returns fell a full 100 bps. Clearly, the capital employed was not churning out profits as before, casting doubt on the effectiveness of the investment already in place, let alone what could be expected on new ventures.

A recent survey by Statistics Canada on capital spending paints a very disquieting situation. Total spending intentions are expected to fall by 4.4 percent led by a decline of 9.3 percent in the private sector which accounts for about two-thirds of total capital investment. Moreover, expenditures in manufacturing are poised to drop by 11 percent. It is no wonder that the forecasts for the Canadian economy remain tepid. The real engine of growth is badly misfiring.

In addition, there is considerable excess capacity in all sectors. Capacity utilization ratios are currently running at 75 percent compared to the longer-run average of 80 per cent. (See Table 1). With excess capacity and falling rates of return, Canadian corporations have no real incentive to undertake capital investment.

The Longer Term Impacts
The Bank of Canada, in its most recent monthly report ( April, 2016) concluded that Canada's potential GDP growth has weakened over the past year.Potential GDP is comprised of the growth in the labour force plus the growth in labour productivity. The Bank downgraded Canada's  potential GDP growth from 1.8 percent to 1.5 percent.( see Table 2).  Labour productivity growth will exhibit a marked decline over the next three years, according to the report.  The Bank argues that since

" the trend in labour productivity influences the outlook for potential output, the current weakness in trend labour productivity reflects the decline in business investment."
Thus, we come full circle: the lack of new business investment leads to poor productivity performance which, ultimately, leads to a lowering of the country's potential growth rate. The slowdown in business investment and its implications are now well- embedded in the economy for the next three years at least.


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Monday, May 9, 2016

Disentangling the nature of Italy’s capital flights

The ECB T-LTROs and the QE efforts are fueling significant outflows toward the core countries, driven by the non-banking sector. 

Guest post by Marcello Minenna

Net balances in the Eurozone continue to widen as capital flows from the periphery to Germany and other core countries. Much of the convergence in net balances that took place between 2012 and 2014 has reversed. As for the underlying reasons, we’ll show that empirical evidence points mainly to the combined effects of the new ECB programs of monetary expansion (T-LTROs and Quantitative Easing).  As of March of this year, Italy reported its largest Target 2 net deficit 2012 (€ -263 billion), followed closely by Spain (€ -262 billion) and Greece (€ -95 billion). Germany’s Bundesbank saw its surplus grow to over € +600 billion once again (see Figure 1).

Figure 1.

The ECB itself has seen its deficit widen to  € -90 billion due to quantitative easing purchases (see Figure 3).  Around 10% of QE assets are risk-shared between Eurozone countries and thus are accounted as an ECB “debt” towards National Central Banks (NCBs).

Figure 2.

This unusual accounting confirms that, also because of complex technicalities involved, a clear explanation of the driving components of this central banks' accounting method continues to prove elusive. Even the same ECB is explicitly warning not to infer bold assumptions from analysis of these data since simplistic explanations could lead to wrong conclusions.

Some academic research on the importance of Target2 balances has progressed considerably from the seminal but disputed work of Sinn (2012). The Sinn research has the merit in attracting attention on the relationship between the current accounts and the Target2 balances of Eurozone countries. A surplus in the current account should lead to a positive Target2 net balance, and vice versa. In this perspective, the Sinn research considers the Target2 balances in terms of a “stealth bail-out” of peripheral countries by the creditor central banks. According to Sinn, in the case a “debtor” central bank would leave the Eurosystem, the Target2 net balance would become immediately payable. A subsequent default of the debtor central bank would turn into a net loss for the Eurosystem to be absorbed jointly by all the remaining members (risk mutualisation or risk-sharing). Whelan (2012 and 2014) contested this view in many papers, pointing out that any central bank can always operate with “negative equity” (in other terms it could offset losses "printing money", without fiscal transfers from the taxpayers).  Now it seems understood (Szécsényi, 2015) that Target2 assets and liabilities could eventually lead to losses in case of a Euro break-up, but these should be a lot less than the raw net imbalances suggest.

At the present, a large part of the financial community seems to acknowledge that diverging net balances in the last two years are driven by purely financial transactions.  The current accounts of Eurozone countries are mainly in surplus (see Figure 2) due to the depreciating Euro and the compression of the level of prices and wages in the periphery (i.e. a phenomenon also known as internal devaluation). Hence, it could be inferred that the intra-European trade between Germany and the periphery (the Sinn hypothesis) is not the leading factor in explaining Target2 net balances.

Figure 3.

Digging deeper, it’s interesting to highlight also the strong correlation between the size of the ECB balance sheet and NCBs Target2 numbers. When the ECB inflates its accounts via expansionary measures, newly created money flows towards Eurozone banks that use it to regulate different kinds of transactions. When they are settled and accounted, these operations produce variations in the Target2 net balances. Let’s investigate the Italy’s case. As Figure 4 clearly depicts, Italy’s Target2 net balance and central bank balance sheet show a 96% correlation between 2011 and 2016.

Figure 4.

In the pursuit to understand movements in Italy's Target2 net balance, a detailed decomposition has been calculated by exploiting financial account data from the balance of payments (see Figure 5). The reconstruction has a good degree of precision, with little unexplained residual flows (the orange bars).

Figure 5.

In 2011 and 2012, core Eurozone banks sold significant amounts of Italian government bonds on the secondary markets because of an augmented perception of Italy’s credit risk (the green bars grew quickly). Those bonds were then purchased by Italian banks, which increased their exposure to national public debt. At the same time, German banks were deleveraging from long-term commercial credit exposure to Southern Europe. Net borrowing by the Italian banks on the Euro area interbank market also decreased markedly, due to the substantial reduction of deposits abroad and the missed renewals of existing loans. These phenomena (together with a progressively higher cost of financing) were signaling stress on the Italian banking sector’s funding practices  (the yellow bars). Together, this led to large capital outflow from Italy to the Eurozone core (denoted with a positive sign in core Target2 accounts; vice versa for Italy). The ECB’s LTROs and other unconventional measures have supplied over € 1 trillion to the Eurozone banks (€ 270 billion to Italy alone) that have been employed to finance the capital flight and transfer risk from the German banking system to the ECB.

When LTROs repayments began in 2013, the ECB balance sheets gradually deflated along with the Target2 net balances. Foreign investment in the Italian public sector resumed, though it did not reach previous levels. The missing amounts were partially compensated by a positive influx of foreign money in the private sector (sky blue bars). The divergence returned in June 2014 when Mr. Draghi launched the new T-LTROs in an effort to revive the sluggish Eurozone credit growth. In March 2015, PSPP’s launch accelerated the growth of ECB assets and had widened the spread between Target2 net balances.

New money flows (TLTROs loans and revenues from the selling of government bonds) reached Eurozone banks but only partially were employed to increase the exposure on national government bonds. A new source of capital flows has emerged and become the primary driver of Italy Target2 negative net balance: a shift in Italy’s private non-banking sector from government and banking bonds to foreign shares and mutual funds.  Looking closer at Figure 6, one can infer that the Target2 net balance (blue line) was only affected by the sell-off and the subsequent repurchase of Italian government bonds (green line) until June 2014. Afterward, foreign investment by the non-banking sector (red line) played a larger role in dragging down the Target2 balance. Moreover, the last few months of decline could be attributed to a renewed – albeit moderate – flight from government bonds.

Figure 6.

As of the beginning of 2016, over € 180 billion has shifted from Italy towards mutual funds located in Luxembourg, Netherlands and Germany. Only 20% of them can be traced back to Italian entities (i.e. round trip funds). The hunt for yield in a unprecedently low-interest-rate environment can only explain part of this sustained capital flight towards Northern Europe. Subtle but persistent redenomination risk (the risk that a euro asset will be redenominated into a devalued legacy currency after a partial or total Euro break-up) affecting Italian assets. Moreover, the fear of adverse effects of the bail-in regulation that came into effect in January 2016 may have had a meaningful role in explaining this massive portfolio readjustment by the private non-banking sector.

References and Further Readings:

Publication of TARGET balances (2015)

Minenna et al. (2016 - forthcoming) “The Incomplete Currency: The Future of the Euro and Solutions for the Eurozone”, Wiley.

Sinn H.-W., Wollmershäuser T. (2012b), “Target balances and the German financial account in light of the European balance-of-Payments crisis”, CESifo Working Paper No. 4051, December.

Szécsényi P. (2015), “Nature of TARGET2 Imbalances”,

Whelan (2012) “TARGET2: Not why Germans should fear a euro breakup”,

Whelan K. (2014), TARGET2 and central bank balance sheets, Economic Policy January 2014


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Sunday, May 8, 2016

Fiscal Policy to the Rescue?

Guest post by Norman Mogil

When appearing before their political masters, central bankers, invariably, urge them to adopt an expansionary fiscal policy. Ben Bernanke, and now his successor, Janet Yellen have pleaded with Congress to adopt a more simulative fiscal policy. Mario Draghi continuously stresses the need for fiscal policy in support of the ECB's easy money policy. Most recently, the head of the IMF, Christine Lagarde, stated that some countries “may have room for fiscal expansion", citing Canada as one country that has "made the most of this space." Indeed, the Governor of the Bank of Canada (BoC) has made it a selling point that they believe that Canada's latest fiscal stimulus measures will have a positive effect on the real GDP. In part, the fiscal policy shift has allowed the BoC to refrain from cutting its lending bank rate.

Monetary policy is reaching its limits in terms of stimulating economic activity and has carried that burden well beyond what was envisioned immediately after the 2008 crisis. This blog looks at the issue of fiscal policy, especially the fiscal multipliers that are considered to be the drivers behind the movement towards fiscal expansion.

The Multipliers

The Keynesian multiplier is at the centre of  the analytical debate regarding the impact of a central government's budget on promoting growth. Simply put, the multipliers measure the bang one gets for the fiscal buck .That is, the amount of short-run economic expansion one gets from a dollar of government spending, or, from changes in tax policy. Multipliers can be calculated to measure any kind of expenditure change on GDP. Thus, for example, if government spending were to increase by $100, leading to an expansion of $150 in GDP, then the spending multiplier is 1.5. Other types of multipliers can measure the impact of government transfers or of specific tax changes affecting profits and wages.

Using historical data, a recent IMF study calculated the average multiplier impact for major industrialized countries (see Chart 1). What is striking is the relatively wide-ranging implications of stimuli for these countries. The US and China have experienced a multiplier effect of 1.5 and 1.7, respectively; Canada, Australia and the Eurozone have experienced less effective results. We will return to this point later.

Not all fiscal stimuli act with the same degree of potency. Chart 2  separates the type of stimulus between " investment" and "tax" measures.  The governments obtain the greatest bang for the buck when undertaking infrastructure projects, both for their immediate impact on jobs and income as well as for their longer term benefits in adding to productive capacity (e.g. urban transportation systems). Next in importance are stimulus programs generated by increasing government consumption of goods and services  (i.e. day-to-day expenses associated with government operations).

Tax measures, on the other hand, have not proven to be anywhere nearly as effective in promoting growth. The impact of reductions in personal or corporate tax cuts are de minimis. Since some portion of a tax cut is usually saved rather than entering the spending stream,  tax multipliers are lower than government spending multipliers.

Thus, economists have long urged governments to look to stepping up their capital investment activities as the primary driver of fiscal stimulus policy.

Conditions Affecting the Multiplier

How effective fiscal policy can be depends largely on the following conditions:
  • the stage of the business cycle. If the economy is fully utilizing all its resources, then a stimulus program would have no effect and might even worsen conditions as the government would tend to "crowd out" the private sector in the competition for workers and for physical and financial capital.  This is  not the situation today. Government expenditures simply will augment aggregate demand and contribute to overall growth without any inflationary results. In fact, recent research has shown the multipliers are likely be higher those of the past--- there is that much slack in the economy. Furthermore, some researchers even go further and argue that these expenditures will, in time, ease, not exacerbate the government’s long run budget constraint (1).
  • reliance  on international trade. For countries such as such as Canada, Australia and those in the Eurozone, international trade accounts for as much as  25 percent  or more of national income. In these cases, there will be some leakage as consumers and businesses purchase products made overseas resulting a net reduction to national income. This may account for why the multipliers for those countries are lower than for the US and Japan which are more closed economies.
  • the level of interest rates. As long as interest rates are less than growth in nominal income, the amortization of the additional liabilities will negative. This is a very cost-efficient means to finance long term infrastructure projects.
  • on the fiscal policy mix. As we pointed out earlier, it is important to emphasize government " investment" expenditures over "tax" expenditures as a means of stimulating growth. The mix often depends on the political forces at work at the time that budgets are being drawn up.
We did mention that economists debate the value of fiscal stimulus. Some point to the experience of the US stimulus bill of 2008 had very little impact. However, that program was dominated by tax cuts which have the smallest impact of any stimulus measure. Also, the size of the program, roughly $750 billion was less than 1 percent of the economy and would not likely have produced the desired impact. The program was designed to kick start only, rather than to provide for sustained increase in economic activity.

Summing Up 

As the monetary policy options are exhausted, the industrialized countries are going to look to fiscal policy to boost growth. In the recent the G-20 meeting, the IMF  recommended the G-20 stand ready to implement coordinated stimulus equal to 1 percent to 1.5 percent of GDP. More importantly, should this be a coordinated action the multipliers cumulative affects would be even greater than each country going it alone. Hence, the urging by the IMF to have the major players work together.  A tall order, indeed.

(1) "Fiscal Policy in a Depressed Economy",  J. Bradford DeLong U.C. Berkeley and NBER  Lawrence H. Summers Harvard University and NBER,2012

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Monday, April 11, 2016

Understanding Negative Interest Rates

Guest post by Norman Mogil

When the central banks of three European countries and the European Central Bank (ECB) itself introduced negative interest rates (NIR)  in mid -2014, many considered it be a temporary measure, a new experiment in monetary policy. But when the Bank of Japan did the same in January 2016  and when the ECB  pushed rates further into negative territory in March 2016, the international investment world stood up and took notice. Policy makers are now prepared to test this unconventional technique in an effort to stimulate growth and tackle deflation.

The financial press is full of articles on the dangers of this policy. These unconventional moves have provoked a lot of criticism, especially from the banking community who fear a strangulation of normal banking activities. A lot has been written about the dangers that NIR  pose to the stability of banks and to the possible harm to savers and investors alike. This article is an attempt to put the whole question of NIR into a more balanced perspective. To begin with, it is important to have some background to why and how NIRs have come to characterize so much of government debt.

How Pervasive are NIRs?

 According to the JP Morgan international bond index, approximately 25% of its government bond index is in negative territory ( see Chart1). More importantly, the size of that market has grown rapidly and dramatically from zero in mid- 2014 to more than US$6 trillion today.

Source: FT

Table l lists the countries whose official central policy calls for NIRs and whose interbank lending rates are negative. The interbank lending rates are a measure of how willing commercial banks are prepared to lend to each other on a very short term basis. In Europe, alone, nine countries' interbank lending rates are in negative territory.

Initially, the sub-zero debt instruments were confined to the very short end of the yield curve. However, as Chart 2 reveals, NIRs have been extended to the middle and longer ends of the yield curve. In Germany, sub-zero rates extend up to five years and, in Japan negative rates extend out to 10 years - the Japanese 30-year bond trades at a mere 0.50 percent. It should be emphasized that, although the central banks set only bank policy rate, the market place determines all rates along the yield curve from 2 years to 30 years. Clearly, the goal of lowering long-term interest rates has been achieved in Europe and Japan. It will take an extraordinary shift inflationary expectations to eliminate negative rates this far out on the  yield curve.

Source:, March 18,2016

In the case of non-Euro countries like Sweden, Denmark and Switzerland, these countries adopted a policy of NIR to hold down the external value of their domestic currencies. Money was flowing into these nations' coffers from the Euro countries, putting undue upward pressure on their domestic currencies to the detriment of their trade and capital balances. Despite the fact that the Federal Reserve has signaled that it wants to raise the short-term rates as part of its efforts to `` normalize`` monetary policy , Janet Yellen said last November that certain economic conditions could put negative rates "on the table". Never say never.

NIR bonds are not solely confined to the government sector. Recently, such blue chip European corporations as Nestle, the energy corporation EDF,Royal Dutch Shell and drug makers, Sanofi and Novartis, have been trading at sub-zero rates for more than a year .Chart 3 sets the dramatic drop in investment grade corporate bond yields since the announcement of NIRs by the ECB in 2014.

Source: FT

What Gives Rise to Negative Rates?
One way to approach this question is to consider the nature of a " liquidity trap'. In describing  monetary conditions in the 1930s, John Maynard Keynes coined the term "liquidity trap" in which  declining interest rates fail to promote  greater consumer borrowing and spending. The demand for money from consumers and business owners are no longer sensitive to the drop in interest rates.

Another way to look at this phenomenon is to consider that money is essentially trapped in the financial system--- even at zero rates of interest, the economy fails to show any signs of meaningful economic growth. We have not seen this situation since the 1930s when Keynes first labelled it. So, it is quite a shock to the policy makers that even a zero rate of interest did not stimulate borrowing and spending . Now, some central banks have resorted to introducing unconventional means such as NIRs,

 Economists have cited various reasons for a liquidity trap and some are featured in today's environment:
  • expectation of deflation. In Japan an entire generation since the 1989 financial and property market crash has experienced deflation;  consumers feel no urgency to go out and spend now, since they expect prices to fall further in the near future. In the EU, the debt crisis of 2012 has ushered in a period of austerity, accompanied by expectations of stagnation and further deflation.
  • credit tightening. Following the 2008 banking crisis, banks worldwide have had to raise capital in order to improve their balance sheets ; they are reluctant to lend, regardless of the creditworthiness of the borrowers.
  • savings rate increases. A pessimistic outlook will lead to  consumers increasing their savings as a precaution; the debt crisis in Europe has prompted consumers and government to hold back on expenditures as part of an overall austerity policy. Savings as share of GDP is relatively high in countries featuring NIRs.

Who Buys Negative Interest Bonds?

So, who would buy a NIR bond?
One category include institutional  investors who have to own government bonds, regardless of their returns . Central banks own bonds as part of their foreign exchange reserve positions. Insurance companies and pension funds need to hold bonds as part of their reserve requirements and to match long-term liabilities.And, commercial banks need bonds to meet liquidity requirements.

A second group include speculative investors who  expect bond yields to fall further in response to other monetary policy shifts, eg. the ECB announcing an extension of its bond buying programme ( QE) , Or, these investors anticipate a currency appreciation that more than offsets the loss due to negative yields. Many foreign investors buy Japanese bonds with expectation that the yen will appreciate beyond the loss in yield. In fact, the yen has been strengthening against the US dollar over the last couple months, since the BoJ introduced its NIR policy.

A third group of investors have no alternatives . The security and transactional cost of holding very large cash balances can be very expensive compared to a small loss from an NIR bond. Finally, government bonds ,even if yielding negative returns, are considered as a relatively cheap and safe haven in the time of market volatility.

How do NIRs Work?

Let's clear up a few misconceptions.

First, the negative rates are really aimed at the institutional investor, eg. pension funds, large corporations, The retail investor is not the target and has not been directly impacted; rates may be low, but there are positive for the retail saver.

Second, no government is forcing an investor to accept negative rates. After all, the investor can seek higher returns in more risky assets. In fact, that is precisely the desired goal of the policy makers. However, given what happened in the 2008 financial crisis, it is entirely rational for a risk-averse investor to buy a highly liquid and safe investment to protect against a future financial crash. For example, foreign banks have approximately 17 billion Swiss francs on deposit in the Swiss central bank at negative rates as a way of protecting capital and having access to liquidity; both are prudent corporate policies.

Third, Japan, for example, cut its deposit rate on cash held at the BoJ by the commercial banks that exceeded the legally required reserves; banks often find themselves with cash reserves in excess of their  banking requirements and those excess reserves are normally lent to the central bank. The BoJ wants to encourage the commercial banks to make these excess reserves available for lending to consumers and businesses. The BoJ made it clear that the aim is to make more money available at lower costs to stimulate growth and inflation.

The Bank for International Settlements (BIS) recently examined the how NIRs are implemented within Europe, the area with the most experience to date. The BIS concluded that:
  •  NIRs work through the money markets and other interest rates in the same way that positive rates do; no disruptions were identified.
  • the one major exception is that banks have been reluctant to pass negative rates to their retail customers; the fear was that negative rates would lead to major deposit withdrawals.
  • the drop in longer-term interest rates has taken place at the same time as ECB adopted a programme of purchasing government debt ( QE ); so, it is difficult to isolate the impact of negative rates from that of its bond buying programme.
The BIS concludes that `` looking ahead, there is great uncertainty about the behaviour of individuals and institutions if rates were to decline further into negative territory or remain for a prolonged period`` . Nevertheless, the policy, to date, has not harmed the banking system nor has it disrupted savings patterns (1).

Are NIRs necessary?

NIRs are part of a long list of unconventional monetary policy moves which include purchases of government bonds, purchases of mortgages and  other asset-backed securities,forward guidance and currency devaluations. To date, these efforts have failed to stimulate growth. Had these governments adopted expansionary fiscal policies, there would not be the need for so many unconventional policy moves, of which the latest is NIRs. In a sense, governments have been struggling to shake off slow growth and deflation with one hand tied behind their backs.

Summing up, NIRs have permeated the banking world, especially in Europe and Japan and by all accounts this is not just a temporary condition. Subzero rates now extend into the longer end of the yield curve as the demand for government  debt continues to remain strong. Reasons vary by investor groups as to why they participant in what is , on the surface, a counter-intuitive investment strategy. The strategy may not have been necessary had governments adopted  more expansionary fiscal policies. Nevertheless, the jury remains out regarding the longer term effectiveness of NIRs.

(1) BIS `How have central banks implemented negative policy rates? ", M. Linnermann and A. Malkhozov, March 2016



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