Sunday, December 20, 2015

Negative Interest Rates for Canada?

Guest post by Norman Mogil


In his December 8th speech, the Governor of the Bank of Canada, Stephen Poloz introduced the possibility of negative interests as a policy tool . He was adamant that the Bank was not embarking upon this policy, rather it was exploring the implications of using such an unconventional policy instrument in times of economic shock or major dislocations. It was his view that  " it's prudent  to be prepared for every eventuality " (1)

Yet, his discussion went beyond just academic musings and into the practical  realm of how would negative interests  impact  the Canadian financial markets . In 2009, the Bank  looked at  the application of  negative interest rates ,but  rejected  it as a possible tool. What has changed since that time that  caused the Bank  to come out in favour of such an unprecedented policy move?

I believe there are two important developments that go a long way towards explain the shift in the Bank's thinking  towards the " unthinkable".

First, the Canadian economy has weakened further since mid-2015, raising the spectre of a rate cut to revive growth; negative rates are just another form of rate cutting.

Secondly, the experience with negative rates in the Eurozone and in the EU in general has proven to be more positive ( less to be feared) than many experts thought early on; some half dozen countries now experience negative rates and continue to function without  major market disruptions. Before we look at Canada, specifically, it is helpful  to explain  why some  central banks chose to establish negative rates.

Why Go Negative

Negative interest rates are introduced for one of two reason.  In the case of  Switzerland, it  had to manage  a very sharp and sudden  upward pressure on Swiss Franc ; investors were fleeing the Euro  and  the sudden  capital inflows from the Eurozone   drove the  value of Franc to dangerously high levels.   In  the case of Sweden, the   country was facing  serious deflation and an ensuing recession ; the central bank  turned to this unconventional policy to reverse this trend.  The Eurozone adoped negative rates  to combat both deflation and a weak economy.

Canada's recent economic performance continues to face serious headwinds.

*  GDP growth over the past 12 months stands at 1% annualized;

*  Unemployment has remained stubbornly high at 7%

*  Consumer prices are increasing at no better than 1% yearly, well below the target rate of 2%;

* WTI oil prices have fallen to around $35bbl ( and Canadian oil sells at a further discount to as low as $22 bbl); and,

* Our balance of trade continues to worsen; non-energy exports have not filled  the gap created by the loss of oil export revenues.

Although the Bank continues to express optimism about the near term , it fully recognizes that there is a significant output gap ( as high as 1.5%) that will not be closed before 2017, at best. Given the most recent economic data mentioned above, closing this gap remains a very tall order, indeed.

A New View on Negative Rates

In 2009 the Bank believed that it should not drop its policy rate below 0.25%. It maintained that zero or negative rates were be too disruptive to money market funds, resulting in large money outflows and a reduction in liquidity; both would harm the smooth operations of the credit and equity markets. As for the market for long term financial products, there was a real concern that life insurers and pension funds would not be able to match their long term liabilities, if yields on long term bonds fell to below investment requirements.

Recent research by the Bank's staff have turned up evidence to the contrary. In a  discussion  paper by Bank staff, it is  argued   that " negative policy interest rates do not appear to have caused significant volatility...the transmission has been swift... through the exchange rate". Also," money markets have continued to function long as there is a positive spread to encourage borrowing and lending". And, the paper concludes simply by saying that "recent experience indicates that negative interest rates are indeed a viable policy tool."

This research report has given the Governor the confidence to state that " the Canadian financial markets could also function in a negative interest rate environment".
It seems as if  there is,  almost,  a feeling of relief that this unconventional tool has come out of the realm of academia and into the realm of real world policy making.

More significantly, the Governor stated that the " effective lower bound for Canada's policy rate is around minus 0.5%". In other words, there is considerable room for the bank rate to be lowered to stimulate growth without any adverse impact on the functioning of our financial markets.. It seems that the door is now ajar  the regarding  the introduction of negative rates in Canada.

Canada has  already experienced negative rates of return, as measured by the  real rate of interest. The average yield on Government bonds in the 3-5 year range , when discounted for inflation, reveal an average real rate of minus 0.3%  .Granted that real rates over time vary considerably depending on inflationary expectations, the fact that we have been accustomed to zero or below zero real rates since the 2008 crisis, makes any move towards  nominal  negative rates not as disruptive to the financial markets as once feared. Moreover , the real rate of interest has been well below the average of  1-2%  that has prevailed over many years in the industrialized world.

A final word. In a very recent interview, Ben Bernanke  suggested  that 'negative rates are something the Fed will and probably should consider if the situation arises,” .It seems that there is some meeting of the minds that negative nominal rates  are no longer unthinkable.


1)  Stephen Poloz, "Prudent Preparation: The Evolution of Unconventional Policies" ,The Empire Club of Canada. Dec 8,2015)

2)  Harriet Jackson," The International Experience with Negative Policy Rates"  The Bank of Canada. Staff Discussion 2015-13
3)  MarketWatch, Dec 15, 2015

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Watch the Fed's RRP facility uptake jump at year-end

The Fed's policy announcement to raise rates had one technical detail that didn't get much media attention but is actually quite important. The reverse repo (RRP) rate was not only raised from 5bp to 25bp but the Fed also removed the cap on the RRP facility (which was at $300bn). It means that the program participants such as banks and money market funds can place nearly unlimited amounts of liquidity with the Fed overnight and earn 25bp. For now the Fed made $2 trillion of treasuries available for the RRP operations.

This sets the overnight riskless rate at 25bp which becomes the floor for the Fed Funds rate (and other money market rates such as commercial paper and private repo).

The immediate demand to place overnight funds with the RRP facility has been relatively modest at $143bn (note that we should see the reserves at the Fed drained by the uptake amount in the next H.3 report).

Source: NY Fed

Instead of using RRP, many market participants are enjoying the tightness in the private repo markets as general collateral (GC) repo now clears about 20bp above the RRP rate. The key reason for this relatively elevated spread is the increased regulatory pressure on banks to cut back on their balance sheet usage.

Source: DTCC

However the RRP demand is expected to spike at year-end as banks focus on window dressing. Given the somewhat elevated level of market stress and no cap on the RRP facility size, the uptake will be particularly large this time as we saw at the end of Q3 (note that the chart below shows the total reverse repo held by the Fed, which includes RRP).

Source: St. Louis Fed

Some are concerned that given the pressure on banks' balance sheets, this shift to RRP could disrupt the private markets on December 31st and send the GC repo rates to new highs.


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Tuesday, December 15, 2015

The Fed will hike the Fed Funds target range by 25bp but the rate will rise by only 20bp

Given the upcoming FOMC meeting, it's worth revisiting some of the mechanics around the rate hike. The FOMC is fully expected to lift the Fed Funds target range by 25bp - from 0-25bp to 25-50bp.

The current Fed Funds rate is around 13bp. Does it mean that after the FOMC meeting we will see the rate at 38bp, exactly 25bp above the current level? A number of analysts don't think so. Here is why.

In theory banks lend to each other overnight at a rate that on average should equal to the Fed Funds rate. However interbank lending has declined sharply after the financial crisis as banks rely on other sources of financing.

Source: St Louis Fed

A great deal of the overnight activity these days comes from the Federal Home Loan Banks (FHLBs) who often place their excess liquidity with commercial banks. They do this because they don't receive interest on reserves as private commercial banks do. Instead they place excess funds with commercial banks in order to receive some non-zero rate. That interbank rate however has to be some amount above the riskless overnight rate in order to make these transactions worthwhile for the FHLBs. That riskless rate in this case is based on the Fed's RRP (see post), with the latest auction setting at 5bp.

Source: NY Fed

The current spread between Fed Funds and the RRP is about 8pb and some view this spread as remaining relatively constant immediately after the hike. The FHLBs' demand to place liquidity will keep the Fed Funds rate at the lower portion of its range but at this minimal spread (8bp) above the RRP rate.

This week the Fed will be taking the following action.

Source: Morgan Stanley

With the RRP rate going up to 25bp and the spread to Fed Funds remaining constant, the new Fed Funds rate would move to 33bp. And that is 20bp (not 25bp) above the current level.

As a result of this projection, the calculation for the rate hike probability implied by the Fed Funds futures would need to change. Instead of being around 79% (chart below), which is based on the 25bp assumption, this week's rate hike probability is closer to 98% (based on the 20bp increase). The December 16th liftoff is now fully priced into the markets.

Source: CME


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Monday, December 14, 2015

Canada Need Not Fear Deficit Financing

Guest post by Norman Mogil

As the new Liberal Government takes shape, all eyes will be focussed on how it proposes to finance its ambitious agenda . Deficit financing will be at the centre of all discussions concerning jobs and economic growth over the next five years. In its latest Economic and Fiscal Update (November, 2015), Canada's Finance Department recognizes  the damage that has already occurred from plunging commodity prices, the deterioration in the country's terms of trade and the worldwide slowdown . The major question facing the Government is:  What is the capacity of the Federal finances and the Canadian economy to meet this challenge?

Fiscal Outlook

The Parliamentary Budget Office(PBO) and Finance Canada each produce a fiscal outlook to 2020-21 based upon existing government policy at the time. On balance, there is no material difference between the two forecasts over the next 5 years. PBO average annual  deficit is  $2.9 billion, ; the Government annual average  deficit is $2.7 billion. However, there is a sizable difference in the fiscal year  2020-21. The Government projects a surplus of $ 6.6 billion while the PBO anticipates a deficit of$4.6 billion . The Government forecasts assume a more optimistic forecast for revenues personal and corporate taxes as well from the GST ( national sales tax) .

As with all forecasts, the further out one goes the less reliable are the projections in either direction. For our purposes, we will use the Government’s projections for the period as a whole as a benchmark with which to explore the capacity of the Canadian economy to manage Federal deficits. The analysis would not be materially different had we adopted  the PBO figures.

Table 1  is a summary of the fiscal outlook to financial year 2021 prepared by Finance Canada, the department responsible for the national budget.  These projects use the former ( Harper) Government fiscal 2015 fiscal framework, update to November 2015. None of the new (Trudeau) Government policies are included.

A couple key metrics standout. First,  over the next three years ( 2016-19) the Federal annual deficit will average about 0.1% of GDP--- well within the  comfort zone and not out of line historically. Expected economic growth, although modest over the  next 5 years, will likely provide sufficient revenues to absorb the annual deficits so that the level of outstanding  Federal debt at the end of period remains largely unchanged. Second, the   Federal debt outstanding  as a percent of GDP actually falls slightly  from 31% in 2015/16 to 25.2% by 2020/21.  By way of    comparison ,the 2021 forecast  represent the lowest ratio  in over  30 years. ( see Chart 1).


Canada has always been well-received in the capital markets at home and abroad ; bond auctions continue to be  well covered and receive firm bids.  More importantly, as Chart 2 demonstrates, the entire Canadian government yield curve has shifted downwards in the last 12 months , a reflection of low inflation expectations and confidence in the quality of the security sold. Of late, there has been shift towards issuing longer dated bonds to take advantage of the falling long term rates ( 10-30 year terms). Accordingly, the weighted - average rate of interest on public  market debt has fallen to 2.37 per cent in 2013–14 ; this average  interest rate  still stands above the current yield  for long bonds. Thus, any additional long-term issuance will  contribute to a further  reduction in average cost of refinancing.

The IMF refers to fiscal space  as " the room in the public sector budget  that allows government  to
provide resources for a desire purpose without jeopardizing the sustainability of its financial position". Canada is  in no way jeopardizing the Federal budget  by running these anticipated deficits; the size relative to GNP and the servicing costs are well within acceptable range.. More importantly, should the fiscal restraints be relaxed to accommodate additional borrowing aimed at developing infrastructure projects, these projects have the potential to add to future revenues and thus  pay for themselves over the longer term.

Comparison to US Stimulus Programs

Parliament opens the first week of December at which time Canadians will learn more of the programs and policies that will constitute the Federal budget and hence the anticipated future deficits. At this point we can assume that the Liberal's platform , featuring infrastructure spending,  individual spending programs, and  tax changes aimed at the redistribution of income will be at the centre of the next Federal budget. The Liberal party’s  platform  anticipates a budget deficit not to exceed $10 billion in any year.

American readers  should note that what is proposed by the Canadian  Government is quite different from  the American Recovery and Reinvestment Act, 2009( Stimulus Bill ) . That bill was designed  as an emergency measure to kick start the US economy after the financial crisis of 2008. The main thrust was tax relief for  the individuals  and corporations to save and create new jobs;  a much small component included  spending on new infrastructure . A secondary goal was to provide immediate relief to those state and local governments hardest hit by the steep recession. Both countries have adopted a Keynesian approach to stimulate growth; the principal difference is that the US program was conceived as an emergency situation to stop the economic free fall of 2008; the Canadian programs are designed to add to and sustain growth over a longer term.

Shifting  the Burden to Fiscal Policy

Prior to the 2008 crisis and recession, the Federal Government was running budgetary surpluses; in 2009 all that changed  and Ottawa immediately shifted towards deficit financing.  However, within a year the previous Conservative ( Harper) Government adopted a policy deficit reduction by  “starving the beast”, a deliberate policy of squeezing revenues ( reduction in the Federal sales tax, GST) and cutting public expenditures ( Chart 3).  By 2014 the deficits had virtually disappeared. During the recent election campaign arguments were advanced that this relentless reduction in the deficits came at the expense of economic growth.

With the advent of the Trudeau Government  deficits will now  shift the burden to stimulate the economy away  from monetary policy. The Bank of Canada , like all central banks , has been active in reducing the cost of borrowing; in 2015, alone, the Bank rate has been cut from 100 bp to 50bp ,largely in response to the swift decline in oil prices and the serious slowdown in the Canadian economy, especially in the  spring and summer months. Moreover,  monetary policy has been aided by the  30% decline Canadian  dollar over since 2013. However, monetary policy can do only so much to promote growth. Now, fiscal stimulus  will be added to the  growth policy mix.


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