Monday, 19 January 2015

Swiss i-flation and the absurdities of negative rates.

The Swiss National Bank has managed in one fell swoop to conjure up deflationary pressures beyond the worst fears of the ECB. A 20% currency move in a day has resulted in record withdrawals of Euros from ATMs and mass migrations across the borders to fill up on fuel and empty the shelves of supermarkets during this "20% Off Everything Sale” for Swiss shoppers. There is a teeny positive for Europe in that anywhere 30km from the Swiss border can raise prices and create a bit of Euro inflation due to the massive new demand, but it won’t take long before Swiss retailers drop prices at the next restocking as the goods on their shelves are cheaper to import and basic competition means they have to. At which point all inflation measures in Switzerland go deeply negative.

To balance this the SNB has cut interest rates on sight deposits to -0.75%. Interest rates have been negative at -0.25% for some time, but we have coped with the logic of Swiss negative rates by confining all things Swiss to a little box that works in a parallel universe of finance on different laws of financial physics, where cuckoo clocks, expensive watches, hard cheese and mountain shaped chocolate bars operate in their own airport duty-free shop of unreality.

But a move to -0.75% is hoped to counter the huge deflationary pressures via the effect on FX with regards to negative carry for overseas investors which will weaken CHF and the via the effect on Swiss locals encouraging them to spend money rather than holding it in banks where they are charged for the pleasure.

With regard to FX moves, carry costs are only a detractor if those costs exceed any gains perceived to be coming through underlying price moves. If we assume USD/CHF has a 1% negative carry (note that is 1% over a full year) then they are hardly a consideration when spot prices are flying around by that amount a day, an hour or, as with last week, a fraction of a second. It only becomes a consideration when all other considerations are neutered, hence quiet markets tend towards carry creep.

As for the domestic saver what do negative rates mean to them? At the moment negative yields sit firmly in electronic-money land with paper money immune from holding fees other than the cost of storage and security. In the case of Switzerland we have seen demand for highest denomination notes go up through the roof. The most up to date on the SNB website are for 2013 and one can only assume that since then demand has only increased.

As the SNB themselves have noted  "The high proportion of large denominations indicates that banknotes are used not only as a means of payment but also – to a considerable degree – as a store of value.” .

How could the powers that be detract from this parking of money in cash rather than forcing it to recycle into the economy? Other than introducing unenforceable laws about maximum cash holdings, an alternative is to reduce the supply of bank notes in issue. This could lead, through the arbitrage of holding costs, to bank notes trading at a premium to face. 1010 electronic CHF for a 1000 CHF note sir? If we are to move into extreme absurdum thoughts, other fanciful ideas could include biodegradable notes that decay under your pillow or perhaps a reverse bank note auction on Saturday evenings on prime time TV where random bank note numbers are drawn and those notes cancelled!

But what do we call this new scenario? It's related to the cost of cash itself in money terms rather than other asset terms. It isn't inflation and it isn't deflation. It's off on an axis all of its own where cash is subject to its own inflation, creating all sorts of confusion. So far the only kind of 'flation' it has produced in the real world is imaginary and theoretical rather than observed. Just like the imaginary numbers we learned about at school, perhaps we should call it i-flation.

The whole idea of making money a costly and toxic asset does lead us into a parallel universe of negativity with negative money spawning from negative rates, where money avoidance is the game. Negative pay, you are paid to take food from shops, paid to fill up with fuel, muggers would hold you up at gun point and stuff your pockets full of money and most ironically bankers are made to take the biggest bonuses possible. Basically the name of the game is to keep your bank balance as negative as possible. Which socially would be quite acceptable as the 1% and the 99% immediately find their positions in life reversed. Cheaper than revolution.

* This post has drawn massively from a post I originally wrote on the Macro Man  blog back in 2012 when Euro rates went negative. But it is so topical now it was too apt not to.

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