Negative Interest Rates through the Lens of the Swiss Fixed Income Model

Transcription

1 Negative Interest Rates through the Lens of the Swiss Fixed Income Model Introduction Investors continue to witness negative nominal interest rates in Switzerland and across many markets in the eurozone, both at the short end and further out the yield curve. In fact, as of February 3, 2015, the Swiss term structure was negative out to 10 years (see Exhibit 1 below). In this Research Bulletin, we delve into the dynamics behind this phenomenon, looking across interest rates, FX, and credit markets. We highlight yield, spread and volatility shifts from the MSCI Swiss Fixed Income model in the wake of the Swiss National Bank (SNB) decision to break the Swiss franc peg to the euro. Finally, we conclude with a discussion of the shadow costs imposed by negative rates on money managers. Exhibit 1 Negative Rates Have Existed for Some Time Across Maturities, Particularly in Switzerland. Please refer to the disclaimer at the end of this document 1 of 10

2 Exhibit 2 Negative Rates in Germany. The Dynamics of Negative Swiss Rates We can broadly divide the factors driving negative rates into those that impact the short end and those that impact the intermediate to the long end of the curve. Low and negative short term interest rates have persisted in Switzerland since mid 2012; Exhibit 1 illustrates Swiss yields since October This rate environment has been accompanied by sustained low European growth, with the MSCI Europe Index falling 5.7% for 2014 in contrast to the MSCI World Index posting a positive 5.5% return for the same period 1. In addition to the economic backdrop, on January 15, 2015, the SNB unexpectedly revised its three yearold policy of maintaining a floor of 1.20 on the EUR/CHF exchange rate. This was largely due to persistent EUR selling (and CHF buying) in light of expectations for Quantitative Easing (QE) by the European Central Bank (ECB) and Greek uncertainty. At the same time that it broke the EUR/CHF currency peg, the SNB reduced short term rates in order to discourage inflows, lowering its target deposit rate to minus 75 basis points. This followed a cut announced in December 2014 to minus 25 basis points. Exhibit 3 shows the relationship between the EUR/CHF exchange rate and the actual (as opposed to the SNB s target) Swiss 3M deposit rate. 1 Returns shown are gross returns. The gross returns provide the equity returns including dividends. Please refer to the disclaimer at the end of this document 2 of 10

3 We can glean key elements of the SNB s thought process from their memo dated January 15, On the rationale for the initial introduction of the EUR/CHF floor to protect the Swiss export economy and the subsequent reason for its removal, the SNB stated: The minimum exchange rate was introduced during a period of exceptional overvaluation of the Swiss franc and an extremely high level of uncertainty on the financial markets. This exceptional and temporary measure protected the Swiss economy from serious harm. While the Swiss franc is still high, the overvaluation has decreased as a whole since the introduction of the minimum exchange rate. The economy was able to take advantage of this phase to adjust to the new situation. The short term rate cut was justified from the viewpoint of maintaining a loose monetary policy: The SNB is lowering interest rates significantly to ensure that the discontinuation of the minimum exchange rate does not lead to an inappropriate tightening of monetary conditions. The SNB will continue to take account of the exchange rate situation in formulating its monetary policy in future. If necessary, it will therefore remain active in the foreign exchange market to influence monetary conditions. More technically we can view the SNB s interest rate decision through an uncovered interest parity (UIP) framework. Under UIP and a floating exchange rate regime, CHF short rates and EUR short rates would be related as follows: CHF Short rates EUR short rates = Forward EUR/CHF exchange rate Spot EUR/CHF exchange rate Clearly, the removal of the floor (and expectations of lower EUR/CHF due to the appreciation of the now freely floating CHF) would lead, all else equal, to a fall in Swiss domestic short rates. 2 See Swiss National Bank discontinues minimum exchange rate and lowers interest rate to 0.75%,, Please refer to the disclaimer at the end of this document 3 of 10

4 Exhibit 3 Exchange Rate Versus Swiss 3M Deposit Rates. Intermediate and long term rates now reflect expectations of fewer rate hikes. Rates on the long end have also declined coincidently with Quantitative Easing, which the ECB under Mario Draghi put into place for 1 trillion on January 22, In addition to the decline in government bond yields, credit spreads have re priced following the SNB announcement. Exhibit 4 shows market movements in Swiss Investment Grade credit (IG) leading up to and post the peg removal/rate cut. Please refer to the disclaimer at the end of this document 4 of 10

5 Exhibit 4 Credit Spreads Have Re-priced. Note that AAA spreads relative to the swap curve had been negative for quite some time before the deeper rate cut announced by the SNB on January 15. We see that immediately after the SNB announcement (red dashed vertical line), Swiss IG spreads widened. IG yields also plummeted, with highly rated paper reaching very low and even negative levels. Quantitative Insights into the Current Risk Regime We next provide some quantitative measures of the FX, rates and credit action observed in Switzerland, using MSCI risk factors in each of these markets as a guide. Exhibit 5 shows daily volatility estimates 3 for the EUR/CHF FX rate (right hand axis in all charts) as well as the Barra Shift, Twist and Butterfly (STB) factors for the Swiss yield curve since November The STB factors reflect parallel, steepening, and bending moves in the term structure. Two facts are telling here. First, it is immediately obvious that the SNB s removal of the EUR/CHF floor sent the FX and rates markets into a markedly different volatility regime. Second, if we turn to the STB factors, the shift factor has led much of the change in volatility regime. Clearly, the FX and rates markets were caught off guard by both the abandonment of the floor and the level of shift in the yield curve. Further, volatilities have remained elevated on the back of ongoing large fluctuations in the Swiss curve. 3 We use as our smoothed volatility estimate the EWMA model with a weight of λ = 0.94, per the following: σ 2 t= λσ 2 t 1 + (1 λ) r 2 t, where σ t is the volatility on day t, and r t is the return on day t. Please refer to the disclaimer at the end of this document 5 of 10

6 Exhibit 5 Volatility Metrics for our Swiss FX Rates and Yield Curve Factor. We can also detect the market s view on rates volatility by considering our implied volatility factor for Swiss rates 4 (see Exhibit 6 below). Interestingly, the implied volatility factor experienced an increase in its volatility ahead of the SNB announcement, before attaining a new level after the peg removal. Again, we see a similar story the Swiss rates market appears to have entered a different regime based on riskneutral estimates of volatility. 4 The implied volatility factor is based on the log return of the market implied volatility of the 10 year yield. Please refer to the disclaimer at the end of this document 6 of 10

7 Exhibit 6 Volatility Metrics for our Swiss Implied Volatility Factors. Turning to credit, we can make some parallel observations using the volatility of our Swiss credit factors (shown in Exhibit 7 below). IG credit risk factor volatility spiked at the same time as the announcement this is in line with the market action in credit spreads discussed earlier. Also note the differentiation in volatility across credit qualities after the announcement. Such differentiation is typical in crisis periods as investors display flight to quality behavior and weaker credits sell off. Please refer to the disclaimer at the end of this document 7 of 10

8 Exhibit 7 Volatility Metrics for our Swiss Credit Factors. Please refer to the disclaimer at the end of this document 8 of 10

9 Conclusion Research Bulletin By abandoning the EUR/CHF peg and establishing negative policy interest rates, the SNB has precipitated dramatic market moves across asset classes. In this Research Bulletin, we have analyzed this new risk regime through the lens of the MSCI Swiss Fixed Income factor model. The model reflects unprecedentedly negative sovereign yields, the differentiation of spread volatility among credit qualities after the peg break, and the observed negative investment grade yields. In the long run, negative yields can impose non obvious costs on investment managers. Intuitively, the lower bound for interest rates is zero if rates are sufficiently negative over a sustained period, then investors would rather hold cash than deposits. 5 Negative short term European rates are already having a deleterious impact on large money market funds at the time of this writing. 6 Indeed, during the financial crisis part of the U.S. Federal Reserve s rationale for maintaining positive rates was the effect of a sustained zero or negative rate environment on the viability of money market funds. The minutes from the December 16, 2008 Federal Open Market Committee meeting 7 (the last time the federal funds target was lowered) explicitly state that Zero or near zero rates cause a high volume of fails in the Treasury securities market, leading to decreased liquidity in that market and potentially in other fixed income markets. And if short term rates remain very close to zero, some money market funds probably will close. Such costs may argue against cutting the target funds rate to zero and driving the effective rate closer to zero. If the SNB policy proves sufficiently costly, it may be reflected in the term structure factors observed in our models. Short term rates may have to move higher and influence long term rates at the same time. On the other hand, if the SNB s venture into uncharted territory turns out to be stabilizing, we may be entering a sustained period of negative rates, given the European backdrop of low growth and Switzerland s status as a safe haven. 5 In practice, there is likely to be a convenience yield c for holding large amounts of cash in hand versus in deposits at a bank, so that an investor will prefer deposits yielding greater than c % to cash yielding zero. 6 European Money Fund Managers Brace for Losses, the Wall Street Journal, Dec 17, Please refer to the disclaimer at the end of this document 9 of 10

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