Denmark Update Experiences with negative rates Nordea Research, 13 February 2014

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1 Denmark Update Experiences with negative rates Nordea Research, 13 February 2014 Deposit rate is the key monetary policy tool Large effect on the FX market Banks penalised for parking excess liquidity Negative mortgage bond yields have seen the light of day interbank rates could be next in line Jan Størup Nielsen Senior Analyst Economic Research Denmark Anders Skytte Aalund Chief Analyst In early July 2012 the Danish central bank cut its CD rate to -0.20%. This was the first time in the central bank s 200-year history that one of its policy rates was set below zero. And at the same time Denmark became one of the first countries in the world with monetary policy rates in negative territory. Since then Denmark has been in this unique situation with negative central bank rates. In this analysis we take a closer look at the consequences both with regard to the financial sector, the FX market and the short-term interest rates. The deposit rate is the key monetary policy tool The CD rate is the Danish central bank s key monetary policy tool to maintain exchange rate stability versus the euro. The reason is that Danish banks and mortgage lenders currently need to deposit vast sums of money with the central bank due to massive excess liquidity in the money market. This means that the CD rate is a peg for short-term money market rates in Denmark and for the interest rate differential versus the Euro area, which is so critical for the direction of EUR/DKK. CITA, EONIA and Danish CD rate Contents The deposit rate is the key monetary policy tool... 1 Major effect on DKK exchange rate... 2 Banks penalised for parking excess liquidity... 2 Minimal pass-through to retail rates... 3 Negative mortgage bond yields have seen the light of day... 4 What happens in case of negative fixings on floaters?... 4 Can CIBOR become negative?5

2 Large effect on the FX market Major effect on DKK exchange rate Although the central bank s rate cut in July 2012 was just a parallel shift of a similar decision from the ECB, it immediately caused the DKK to weaken versus the EUR. However, it is difficult to tell how much of the weakening was due to the decision to lower the policy rate to below zero, and how much was due to generally rising risk appetite in the autumn of In our view there is no doubt that some investors questioned whether the central bank was willing (and technically ready) to handle negative CD rates. And by eliminating this doubt for good, the bank almost certainly contributed to weakening the DKK against the EUR. EUR/DKK and the Danish CD rate No lower limit for the CD rate but the lending rate will stay above zero Unintended cost is rising The Danish central bank has repeatedly emphasised that in principle there is no lower limit for the CD rate. This means that if the DKK should strengthen markedly again versus the EUR or if the ECB decides to lower its deposit rate, the Danish central bank will not hesitate to send the CD rate even deeper into negative territory. But the central bank has made it equally clear that the lending rate will stay above zero. In a description of its monetary policy instruments the Danish central bank says on its website: With low monetary policy interest rates the room for further reduction of Danmarks Nationalbank s lending rate is limited. The lending rate will remain positive. Banks penalised for parking excess liquidity The most direct effect of the negative CD rate is the (unintended) cost to Danish banks and mortgage lenders. At end-january the monetary policy counterparties had deposited DKK 131bn with the central bank using CDs. This happened even though the central bank had tried to lower the cost of negative interest rates by sharply raising the current account deposit limits to a total of currently at DKK 67,6bn, up from DKK 23bn prior to the rate cut in July The current account rate is currently 0.00%. 2

3 As a result of the massive excess liquidity Danish banks and mortgage lenders have so far incurred interest expenses to the tune of DKK 240m. Lending and deposits at the Danish central bank Small pass-through to retail rates Minimal pass-through to retail rates A key argument for cutting rates is that rate cuts via the transmission mechanism will lead to lower interest rates for businesses and households. However, as elsewhere in Europe the effectiveness of the transmission mechanism in Denmark has declined over the past years in the wake of rising capital requirements and growing cost of capital. This means that the negative CD rate only to a very limited degree passes through to the deposit rate offered to households. The pass-through to deposit rates offered to corporates is somewhat higher. Lending rates Deposit rates 3

4 Short government yields have been in negative territory for long Yields on a few mortgage bonds have also dipped into negative territory Attractive for investors Mortgage bond yields may drop below comparable government bond yields Two different strategies Negative mortgage bond yields have seen the light of day Even before the CD rate was sent into negative territory in July 2012, both T-bill yields and 2-year government benchmark yields were trading below zero. Also ultra-short mortgage bond yields ended up below zero in a few trades. Currently April 2014 ARMs are trading with a yield of 10 bp. So a CD cut is likely to bring these very short-dated covered bonds very close to zero or even in negative territory. It may seem a paradox that there are investors who want to buy Danish mortgage bonds trading at negative yields. The reason is that most investors have a given product universe that they can invest in. If yields on investment alternatives to mortgage bonds drop significantly below zero, it may make sense to buy mortgage bonds trading at negative yields as long as they offer better value than the alternatives. For investors buying mortgage bonds, their investment is secured by a diversified portfolio of properties, and each individual borrower is personally liable for his/her debt for life. This set-up ensures a very strong willingness to repay loans. In addition, mortgage lenders can raise their administration and reserve fees if they were to realise losses on the underlying mortgages. In a scenario with government yields deep into negative territory this type of security may be sufficiently attractive for investors to accept negative mortgage bond yields Spanish mortgage bond yields have periodically traded below comparable government bond yields, which clearly illustrates how the collateral backing mortgage bonds can justify negative yields. However, Danish mortgage bond coupons will likely stay above zero as it is not practically feasible for investors to pay mortgage lenders for being allowed to hold their bonds. What happens in case of negative fixings on floaters? Denmark s second-largest mortgage lender Realkredit Danmark has a CITA floater with a spread on 15 bp and the CITA 6M fixing is currently 5 bp. Thus, if rates are cut with more than 20 bp this bond would get negative coupons. Realkredit Danmark has stated that if this occurs, the coupons on the bond would be floored at zero. The third-largest mortgage lender Nordea Kredit has written in the bond documentation that it has the right to withhold principle payments or write down the principle on the bond in case of negative coupons. Currently the floor on RDs July16 with a spread on 15 bp has a value of 5 bp (using CIBOR vols). 6M CITA 1W CIBOR 4

5 Substantial excess liquidity could result in negative interbank rates CIBOR vs. CITA Can CIBOR become negative? In July 2012 some of the ultra-short CIBOR rates were negative for six days. But do negative CIBOR rates make any sense at all? CIBOR reflects the rates at which prime banks are willing to lend each other money. It may seem odd that banks want to pay for unsecured interbank loans. Still, this happens every week in the very short-term interbank market (the tomorrow-next or TN rate). The reason why the TN rate is negative some days is that the banks' overall excess liquidity exceeds the limits on current account deposits (DKK 101bn) and the marginal rate is thus the CD rate of -10 bp. The average TN rate is currently around -6 bp. The spread of 4 bp between the -10 bp CD rate and the -6 bp interbank rate reflects the difference between the risk-free rate (CD rate) and the short interbank rate. The difference between CIBOR and CITA is often mentioned as an unsecured versus a secured rate. However, this interpretation should be viewed with caution. It is correct that a CITA swap is typically without exchange of principal and thus no principal risk. But a CITA swap is based on the unsecured TN rate and CITA is therefore an expression of the weighted average of the expected short unsecured rates. In other words, the CITA rate corresponds to a strategy of rolling unsecured 1-day rates. So it would be incorrect to view CIBOR-CITA as an unsecured versus a secured rate. An example of why this interpretation should be viewed with caution is a comparison of the CIBOR 6M fixing with a swap with a life of six months with two fixings based on CIBOR 3M. This is not a case of an unsecured versus a secured rate but a tenor basis. Nordea Markets is the name of the Markets departments of Nordea Bank Norge ASA, Nordea Bank AB (publ), Nordea Bank Finland Plc and Nordea Bank Danmark A/S. The information provided herein is intended for background information only and for the sole use of the intended recipient. The views and other information provided herein are the current views of Nordea Markets as of the date of this document and are subject to change without notice. This notice is not an exhaustive description of the described product or the risks related to it, and it should not be relied on as such, nor is it a substitute for the judgement of the recipient. The information provided herein is not intended to constitute and does not constitute investment advice nor is the information intended as an offer or solicitation for the purchase or sale of any financial instrument. The information contained herein has no regard to the specific investment objectives, the financial situation or particular needs of any particular recipient. Relevant and specific professional advice should always be obtained before making any investment or credit decision. It is important to note that past performance is not indicative of future results. Nordea Markets is not and does not purport to be an adviser as to legal, taxation, accounting or regulatory matters in any jurisdiction. This document may not be reproduced, distributed or published for any purpose without the prior written consent from Nordea Markets. 5