Don’t Dwell on the Negatives

With interest rates at record lows across most of the developed world, central banks are continuing to push ahead with unconventional policy measures in an attempt to kick start sluggish growth. Quantitative easing (QE), central banks’ weapon of choice since the financial crisis began in 2008, was initially very effective in averting the worst of the slowdown. However, it now seems to be suffering from diminishing returns as the market perception evolves from one of awe to indifference with each new round.

The law of unforeseen consequences is particularly important from a cash management perspective when you examine the effects of QE. Corporate treasurers face a tough choice in the current environment because QE has been so effective at suppressing interest rates. Do they chase yield but take on increased default risk, or park cash in perceived safe assets and earn a paltry return?

Worryingly, the largest unforeseen consequence of all this monetary easing is the usual signals that force politicians to act and make the kind of structural reforms needed, in the form of higher borrowing costs, have been absent in this recovery. In the absence of market pressure incentivising politicians to act, meaningful reform has been slow going. This has major implications for the bond market, because indebted nations may not have enough powder left in the barrel should they get another negative shock. Credit ratings agency Moody’s last month
downgraded the UK
by one notch, from its prized triple-A rating to Aa1, citing exactly that reason. The bond market in heavily-indebted countries looks a risky place to be at the moment for treasurers seeking safe havens.

Bring in active currency management by central banks and you add a third, potentially very disruptive element into any decision. Negative interest rates, which as Bank of England (BoE)deputy  governor
Paul Tucker
has confirmed are becoming a real prospect in the UK, would make the situation harder still, but holding physical cash in note form – effectively stuffing cash under the mattress – is increasingly attractive since negative rates would only apply to electronic money (e-money). Negative rates are one route that authorities could now take, should they deem a lower exchange rate is the best way to boost demand.

Less than Zero

From a cash management perspective low interest rates already pose a problem. Those holding excess cash either for margin strategies, or simply waiting for the right moment to deploy into other asset classes, are punished for doing so by little or no return. Negative rates actually erode the value of cash in the bank by charging to deposit; making effective management of cash even more important. Short-dated government bonds have cash-like features, and should earn a return in excess of cash in normal markets when used extensively to put excess cash to work. However, in the current environment ‘safe’ assets, or the perceived lack of them, is a dominant meme, and the very safest are commanding a huge premium.

Short-dated German debt, for example, is currently yielding a negative nominal interest rate; meaning that investors are in effect paying the German government to lend money. The closure of some money market funds (MMFs) to new money unfortunately seals off another route usually open to cash managers to park excess funds and earn a return.

Currency, specifically when a central bank retains the ability to issue it, plays a large role in deciding which debt is deemed the safest. Europe’s sovereign debt crisis has many causes, but one reason it became so alarming last year was because the European Central Bank (ECB) initially refused to create money to purchase Spanish and Italian debt, meaning eurozone governments were held hostage to the market. The UK, on the other hand, is in part enjoying historically-low yields on government debt because the Bank of England (BoE) remains the buyer of last resort of UK gilts.

Derivative markets offer some hope, providing the ability to lift yield. Swapping dollars for euros, for example, currently offers sufficient return to compensate for the lower yielding German bond compared to US treasuries, and is a key reason the euro remains well bid in the current market. Esoteric types of lending, such as secured lending to banks via the repurchase agreement (repo) market, also offer good returns and remain one of the few areas in the current climate where those with the know-how will continue to make solid returns.

Moving away from
fiat currencies
altogether, gold could be used as an effective cash management tool with negative interest rates. It is a large liquid market and although having a zero yield gold, like physical cash, would be unaffected. Gold should, importantly, also protect from those unconventional central bank policies having unforeseen negative consequences. The downside to gold remains its volatility and its current high price.

Hedging is Vital

Negative rates are uncharted territory. There are very few products in the market that currently provide the security and return required with low rates, let alone negative ones. If security remains preferable over return we may see more government-insured accounts, much like those offered in the US by the Federal Deposit Insurance Corporation (FDIC), which temporarily allowed unlimited coverage for non-interest bearing accounts after the financial crisis.  However, that coverage came to an end as of 31 December 2012 and there is a large amount of money now currently looking for something similar. The Federal Reserve has speculated on what retail products might look like if negative rates were to appear and they range from a bank holding physical cash in a vault to a prepayment credit card.

As we move towards an environment of active currency management by central banks, one thing to avoid at all costs is taking any unhedged currency risk. Moving money from currency to currency chasing yield is understandable, but hedging via the forward or option market is vital. Be selective in what currencies you wish to use. Unless you have existing exposure to currencies where central banks are openly looking to devalue, such as the
Japanese yen (JPY)
, avoid them altogether.

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