Negative Rates: Never Say Never?
The US dollar has remained well bid this week, consistently reaching new highs against GBP, CAD and NZD, while also managing to make some progress against most major other currencies.
Broad trends in risk sentiment were the most likely driver, as US equities saw several days of losses as President Trump’s communications suggested a heightened risk of a new trade conflict with China. However, the main focus for markets, and for central bank communique, has been increasing speculation that major central banks such as the Fed and BoE would be forced to cut interest rates into negatives. A number of fixed income instruments, including Overnight Index Swaps and Federal Funds futures, suggested increasing expectations of negative rates in these economies. This prompted a flurry of central bank communications this week.
The fact that this pricing did not respond to the offensive put on from the Fed and Bank of England suggests that market participants are unwilling to bet against negative rates for now.
A further deterioration in risk appetite or economic conditions could see expectations of policy rates converge to even lower levels. The implications for FX are not straightforward: on the one hand, narrower rate differentials would imply less room for US dollar outperformance. On the other, the type of shocks that would lead to lowering market expectations for negative rates (bad coronavirus news) are precisely those most likely to trigger a flight to safety and therefore boost the greenback. Looking ahead, the response of rate expectations to any further shocks will be worth watching. For NZD, the RBNZ’s willingness to look at negative rates may mean the currency is more sensitive to further depreciation pressures.
OIS markets illustrate tentative, but broad speculation that rates in several economies may go negative at some point over the next year.
The US Federal Reserve saw a number of voting and non-voting FOMC members voice opinions on the prospect of negative rates, all of them broadly in opposition to the idea. Among the most explicit was Dallas Fed President Robert Kaplan, who told CNN “I would be against rates” due to negative effects of the financial system, including intermediaries and money markets, and went on to express skepticism about if they would actually be “helpful”. Minneapolis Fed President Neel Kashkari was less unequivocal, but emphasized the FOMC had been “pretty unanimous” in opposing the measure. James Bullard and Raphael Bostic also questioned their efficacy relative to other policy options. Finally, Chairman Jerome Powell gave a substantive answer to a question on the topic, repeating Kashkari’s message that the FOMC was unanimous in its opposition. Powell went on to say the measure was not being looked at and also said the evidence on their efficacy was “mixed”.
Based on the Fed’s communication, it is unambiguously clear that negative rates are not under consideration and are unlikely to become so at any stage in the second or even third quarter of 2020.
A more likely sequence of policy responses to further downturns in financial conditions, or a poor recovery from lockdown measures, is to begin with asset purchases and an expansion of the Fed’s multitude of credit easing facilities.
Elsewhere, the Bank of England signaled a similarly frosty response to the idea of negative rates, while the RBNZ was far more receptive. The New Zealand central bank went as far as to instruct the domestic banking system to prepare for the measure.
- The Bank of England’s Andrew Bailey spoke in a web conference, and echoed the Fed’s communications approach to negative rates by saying the policy was not being planned for or contemplated. Bailey commented that “from a communications point of view, and therefore from a reaction and expectations point of view, it is a very big step”, perhaps in a nod to the fact that the measures have faces popular opposition and criticism from banks when imposed elsewhere. Deputy Governor Ben Broadbent had expressed broadly similar sentiment earlier in the week in an interview with CNBC.
- The Reserve Bank of New Zealand took a decidedly different approach to the Fed and BoE in this week’s Monetary Policy Statement, which also saw its asset purchase program double in size from $33bn NZD to $60bn. The statement said that a negative Official Cash Rate “will become an option in the future, although at present financial institutions are not yet operationally ready”, and that discussions with the domestic financial sector on the topic were “ongoing”. Ultimately, forward guidance that rates will remain unchanged until 2021 was kept in place. For the first time, the statement included a projection of the “Unconstrained Official Cash Rate”, an illustration of the “broad level of stimulus” the Bank anticipates being necessary, including the effects of asset purchases. The projection fell as low as 2% towards the end of 2020.
WCRS 5 day change, major currencies vs USD
SARB set to cut rates with deflationary period opening space for a 50bps cut
While negative interest rates are a hot topic of discussion in developed markets, it has almost distracted from the underlying issue – self-imposed lockdown measures causing substantial economic damage.
With many economies in Europe and North America beginning or planning their exit measures, further monetary policy loosening is still expected. The same can be said in South Africa, however, the rolling back of containment measures is likely to lag those in developed markets. Currently, South Africa has just north of 12,000 confirmed cases and 219 fatalities, but the risks of a substantial second wave and the prospect of another nationwide lockdown with the economy already in a fragile state has led authorities to err on the side of caution.
Another nationwide lockdown would upend South Africa’s economy.
Prior to Covid-19; the official unemployment rate sat at 29%, the trajectory of the fiscal deficit was steepening, and the economy was stuck in stagnation. The economic conditions have only deteriorated since, despite the government unveiling a support package totaling R500bn. With the fiscal capacity shrinking, South Africa’s government are more than aware that another outbreak that leads to a nationwide lockdown would be detrimental. Authorities are slowly rolling back the phased level of restrictions for this reason. Initially, the government imposed a 21-day lockdown on March 27th, which was later extended by two weeks. The lockdown was then downgraded to a level 4 on May 1st, which allowed commerce to resume, but the pace of rolling back measures has seemingly slowed. Commercial activity has yet to recover with many businesses remaining partially or completely shut, which only deepens the economic contraction.
With this in mind, authorities are currently debating whether to declare the disease a level 3, allowing additional industries to resume operation. However, initial reports suggest this won’t be a widespread policy.
President Cyril Ramaphosa said that level 4 restrictions will remain in place where infection rates are highest in a televised address to the nation on Wednesday. This would see most major cities remain at level 4 where economic activity is limited. With the impending recession only deepening the longer the measures are kept in place, the Treasury has tabled an adjustment budget set for cabinet approval on June 10th or 11th. The details of the supplementary fiscal package are unclear, especially on when it will be up for voting in the National Assembly, but it points towards increasing efforts to stimulate activity and minimise the economic fallout. We expect this tone to be reverberated by the SARB on Thursday 21st at 14:00 BST.
In their April meeting, the SARB not only cut rates 100bps to 4.25% but signaled a further 125bps worth of easing in their repo rate projections by Q1 2021. With inflationary pressures set to remain low for some time due to a collapse in commodity prices and a widening output gap, we see the SARB front-loading their cutting cycle. Not only does cutting rates during the deflationary cycle make sense, but it would also allow time for increased transmission of the rate cuts to the real economy. This would give the SARB’s measures more bang for their buck when lockdown measures are scaled back to a point that the economy can begin to function near pre-virus levels.
As demand conditions pick up, inflation pressures will begin to rise.
Additionally, the pass through of the latest rand weakness will begin to rear its head in the inflation data. In the last quarterly projection model, the pass-through was estimated at 0.13, although it is noted that it may have reduced even further to below 0.1. The SARB also highlights that the inflation pass-through from a depreciation in the rand runs with a long lag time. Should the pass-through coincide with increased economic activity, the SARB may struggle to find space for within their current mandate to lower rates amid a heightened inflationary environment. Finally, we expect the SARB to front-load easing to fill the holes in the economic support measures. While the fiscal package stands at R500bn, roughly 10% of GDP for FY19, only a third of this is classified as new discretionary spending. With the supplementary budget due to be released after the central bank meeting, we expect the SARB to follow its pre-virus playbook and fill the void left by the government’s shortcomings.
Graph: SARB repo projections released in April 14th at their last policy meeting suggest 125bp of easing by Q1 2021
INTEREST RATE FORECAST
Ranko Berich, Head of Market Analysis
Simon Harvey, FX Market Analyst
Ima Sammani, Junior FX Market Analyst