Financial Pacific - How negative can Swiss interest rates become (third party)


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Financial Pacific - How negative can Swiss interest rates become (third party)

  1. 1. Wealth Management Research 23 August 2011Interest rates and bond markets Achim Peijan, strategist, UBS AGHow negative can Swiss interest Caesar Lack, economist, UBS AGrates become? Daniela Steinbrink Mattei, strategist, UBS AG Fig. 1: Effect of SNBs liquidity measures London interbank offered rates with various • After the SNB intensified its liquidity injections as a mean to maturities weaken the Swiss franc, yields have dropped, especially at the short end of the yield curve. 0.6% • Some interest rates have even become negative; however, the 0.5% option to move into bank notes will limit the degree interest 0.4% rates can become negative. 0.3% • Declining interest rates in Switzerland were also supported by global short- and long term yields that dropped significantly 0.2% reflecting worries about future growth. 0.1% 0.0%Liquidity to weaken the Swiss franc 03.01.11 03.02.11 03.03.11 03.04.11 03.05.11 03.06.11 03.07.11 03.08.11In early August, the Swiss National Bank (SNB) started to increasethe amount of sight deposits by repurchasing outstanding SNB billsand later by increasing the amount of outstanding currency swaps CHF Libor 1 Month CHF Libor 3 Monthsas a mean to weaken the Swiss Franc. As a consequence of the CHF Libor 6 Months CHF Libor 12 Monthsextraordinary increase in sight deposits from about CHF 30 bn onemonth ago towards a target of CHF 200 bn, interest rates especially Source: Bloomberg, UBS WMRin the interbank market,e.g. for money market deposits and longerdated swaps up to 3 years have dropped further and are all below Fig. 2: Strong CHF but declining yield spread0.3% now; with some of these rates being reported to be negative. Yield spreads have declined since July supporting theThe lower interest rates are meant to increase the opportunity costs CHFof holding CHF vs other currencies. But with very low interest ratesglobally, this is an almost impossible task, and one wonders if interest 1.6 1.4rates in more negative territory would be the solution (Fig 2). 1.4 1.3Costs of holding notes is the natural limit 1.2Nominal interest rates should not become negative as long as one has 1.2 1the possibility to keep the money in non-interest bearing account or 0.8 1.1in a safe populated with bank notes. Ultimately the costs in terms of 0.6security and storage of notes limits the down-side in nominal rates; 1i.e. they can become slightly negative as a reflection of these costs. If 0.4 0.9a secure non-interest bearing account is available then even slightly 0.2negative rates should not exist. 0 0.8 03.01.11 03.02.11 03.03.11 03.04.11 03.05.11 03.06.11 03.07.11 03.08.11In Switzerland the rate paid on liquidity balances left on the SNBaccount (Giro account) has always been 0%. Under those conditions, Eur 2y - CHF 2y (lhs) EURCHF (rhs)negative Libor fixings are unreasonable: why would a lender offer cashand pay for it, while he could simply let it quietly sleep in SNBs safeheaven? Source: Bloomberg, UBS WMRThis report has been prepared by UBS AG. Please see important disclaimers and disclosures that begin on page 4.
  2. 2. Interest rates and bond marketsOnly if the SNB would drop this bid and charge money for long cash Fig. 3: Long-term yields determine choice of mort-balances, interest rates could become somewhat more negative and gageopen the way to affect other accounts. However, once banks would Yields in percentage point, average maturity of mort-charge more significant negative interest rates on client accounts, the gagesrisk rises that clients would ask for bank notes to put them in a safe or 4.0 6under the mattress. For this reason we think the SNB will not removethe 0% bid. Since if it did so and banks could not pass this on to 3.5clients, bank profits would be harmed, increasing the stress on the 5financial sector, in the medium term. In addition, negative interest 3.0rates would bring a lot of uncertainties for the derivatives markets 4and would expose some market players to potentially dysfunctional 2.5systems, which might not be designed to handle such a case. 2.0 3Taxes on deposits have proved inefficient, in the pastNegative interest rates on deposit rates are not new. The latest exam- 1.5 2ple was applied during the financial crisis when the Riksbank imposedend of August 2009 on deposits a negative rate of -0.25% in order 1.0to reduce cash accumulation. Also Switzerland used this approach of 1 0.5negative rates on foreign deposits from 1964 to 1966 and during the1970s to discourage foreign investors from holding CHF. Another way 0.0 0to punish foreign deposits would be to introduce a selective tax on Mai Aug Nov Feb Mai Aug Nov Feb Mai Augcash balances. The SNB could also force domestic clearers to apply 09 09 09 10 10 10 10 11 11 11such a negative tax on cash deposits left on foreign counter-parties 3M-Libor 10Y govt bondaccounts. However, these taxes have proven to be inefficient in the avg. maturity (right scale)past as it is very difficult to collect the taxes and to preclude strategiesto circumvent the tax. Restrictions of free capital movements would Source: Reuters EcoWin, SNB, UBS WMRbe another mean to restrict inflow of capital from abroad, however,this is not in line with international agreements and also hard to im-plement in a country with a wide range of international links. Fig. 4: Mortgage growth relatively low Billions of CHFFX interventions and pegging as possible next stepsGiven the risk of increasing demands for notes and coins in case of 620 6%negative interest rates and limited success with taxes on deposits inthe past, the SNB might need to start interventions on the foreign 600 5%exchange. However, this also carries a lot of risks as the necessaryamount of Swiss francs to influence the exchange rate could be solarge that the inflation target of the SNB could be seriously threat- 580 4%ened. Pegging the Swiss Franc (temporarily) to the Euro would con-tain even more risks since a fixed peg would lead to an adjustmentof interest rates to foreign levels. This would remove the "penalty" 560 3%the SNB looks to apply and finally make it even more attractive todeposit money in Switzerland. So, we would expect the SNB to peg 540 2%the currency only after interventions have proved to be ineffective.Economic consequences 520 1%Short-term interest rates have been very low and thus very stimulativefor the domestic economy for some time even before the recent de-cline. We think that the pure interest-rate effect of the recent decline 500 0%in money market rates for the economy will be small. Apart from some Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Jul 10 Jan 11mortgages which are pegged to Libor rates, the recent small decline oustanding mortgages y-o-y growth (right scale)in money market rates are unlikely to change the funding costs forthe real economy. Around 20% of all new mortgages are pegged to Source: SNB, UBS WMRLibor. Recent experience has shown that the evolution of the long-term rate heavily affects the maturities of new mortgages: When thebond yields dipped one year ago, the average maturity of newly issuedmortgages spiked. Low-interest rates therefore do not seem to induce Wealth Management Research 23 August 2011 2
  3. 3. Interest rates and bond marketsborrowers to borrow short-term, but to fix low rates for longer. Weexpect that the recent dip of the 10 year federal bond yield below onepercent will induce a spike in demand for longer-term mortgages thissummer. Outstanding mortgages grew in June at 3.6% y-o-y whichis relatively modest - however, low rates carry the risk of over-invest-ment in the real estate sector.Potential effects of negative interest rates on Libor mortgagesA Libor mortgage is based on variable interest rates, which are ad-justed regularly, normally every three to six months to the current Li-bor rates. Libor (London Inter-Bank Offer Rate) is the interest rate atwhich banks borrow from each other money. Because of the very ex-pansive monetary policy stance of the SNB, 3-months Libor is tradingbelow 0.5% since late 2008 and has now fallen to 0.008%. Whilewe believe that Libor rates are unlikely to fall below zero, negativeLibor rates would imply a reversed payout profile of products that arelinked to Libor rates including Libor mortgages. In the retail business,banks charges a spread on top of the current 3- or 6-months Liborrate. Therefore, if we assumed that the Libor rates dropped below thespread fixed in the contract, then investors could receive a payment.If we assume that 3-months Libor mortgages are offered at Libor plusroughly 50 to 100 basis points then - with Libor at zero - the current3-months Libor mortgage would cost roughly the spread. If the Liborwould drop negative and in absolute terms below the spread that isadded, a client who owns a Libor mortgage could theoretically receivea payment. However often the mortgage contract allows the bank toterminate the mortgage, which might happen especially if the fund-ing cost of the bank do not adjust accordingly because depositors areunlikely to pay for the deposit but rather move to bank notes, forexample.ConclusionWe expect the SNB will continue with the liquidity measures as withsight deposits at roughly 140 bn the target of CHF 200 bn has notbeen reached yet. But we also expect the SNB to keep the rate it payson giro accounts at zero. As a consequence, interest rates should notdrop much further at the short end of the yield curve and stay close tozero. However, interest rates at the long end of the yield curve coulddrop further as a result of the current extremely loose monetary policy.However, long term yields are at such extraordinary low levels that wewould not advise to speculate on further declines.Negative rates might still be reported. For example as the middle ratereflecting a negative bid and a positive ask rate. Or in the futures mar-ket where market participants discount the possibility that the SNBwill cut the rate for balances on its accounts below zero or introducea tax on (foreign) deposits.The best way for the Swiss franc to reverse course would be morepositive news out of the Eurozone or from the US and a natural nor-malisation of the exchange rate. Unfortunately, in the current delever-aging phase and struggling economic environment this looks ratherunlikely, for the time being. Wealth Management Research 23 August 2011 3
  4. 4. Interest rates and bond marketsAppendixGlobal DisclaimerWealth Management Research is published by Wealth Management & Swiss Bank and Wealth Management Americas, Business Divisions ofUBS AG (UBS) or an affiliate thereof. In certain countries UBS AG is referred to as UBS SA. This publication is for your information only and is notintended as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product. The analysis contained herein is basedon numerous assumptions. Different assumptions could result in materially different results. Certain services and products are subject to legalrestrictions and cannot be offered worldwide on an unrestricted basis and/or may not be eligible for sale to all investors. All information andopinions expressed in this document were obtained from sources believed to be reliable and in good faith, but no representation or warranty,express or implied, is made as to its accuracy or completeness (other than disclosures relating to UBS and its affiliates). All information andopinions as well as any prices indicated are currently only as of the date of this report, and are subject to change without notice. Opinionsexpressed herein may differ or be contrary to those expressed by other business areas or divisions of UBS as a result of using different assumptionsand/or criteria. At any time UBS AG and other companies in the UBS group (or employees thereof) may have a long or short position, or deal asprincipal or agent, in relevant securities or provide advisory or other services to the issuer of relevant securities or to a company connected withan issuer. Some investments may not be readily realizable since the market in the securities is illiquid and therefore valuing the investment andidentifying the risk to which you are exposed may be difficult to quantify. UBS relies on information barriers to control the flow of informationcontained in one or more areas within UBS, into other areas, units, divisions or affiliates of UBS. Futures and options trading is consideredrisky. Past performance of an investment is no guarantee for its future performance. Some investments may be subject to sudden and largefalls in value and on realization you may receive back less than you invested or may be required to pay more. Changes in FX rates may havean adverse effect on the price, value or income of an investment. We are of necessity unable to take into account the particular investmentobjectives, financial situation and needs of our individual clients and we would recommend that you take financial and/or tax advice as to theimplications (including tax) of investing in any of the products mentioned herein. This document may not be reproduced or copies circulatedwithout prior authority of UBS or a subsidiary of UBS. UBS expressly prohibits the distribution and transfer of this document to third parties forany reason. UBS will not be liable for any claims or lawsuits from any third parties arising from the use or distribution of this document. Thisreport is for distribution only under such circumstances as may be permitted by applicable law.Distributed to US persons by UBS Financial Services Inc., a subsidiary of UBS AG. UBS Securities LLC is a subsidiary of UBS AG and an affiliateof UBS Financial Services Inc. UBS Financial Services Inc. accepts responsibility for the content of a report prepared by a non-US affiliate whenit distributes reports to US persons. All transactions by a US person in the securities mentioned in this report should be effected through aUS-registered broker dealer affiliated with UBS, and not through a non-US affiliate. The contents of this report have not been and will not beapproved by any securities or investment authority in the United States or elsewhere.Version as per June 2011.© 2011. The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved Wealth Management Research 23 August 2011 4