Negative Rates And The Currency War

There have been some noteworthy developments on interest rates over the past week. The ECB's cut of its deposit rate to zero has pushed some short-term market rates below zero. France sold bills earlier this week with a negative yield; Denmark cut its key two-week CD rate to -20 bp.; the Swiss yield curve out five years is below zero (the two-year yields -0.39%, for example, and the five-year yield is now -0.01%).
 
Some observers have suggested this is a new front in the currency wars.
While recognizing the competition between countries, this formulation seems to be an over generalization. There seems to be at least three different reasons that have driven rates so low. First, some countries are contracting or suffering weak growth, which was a key factor behind the ECB's rate cut.

Shifting Savings
Second, addressing weak growth is not just a function of policy. Funds have flowed into Denmark and Switzerland not because the economies and asset markets are booming. Rather, investors fleeing the European debt crisis and fearing a redenomination risk have shifted their savings out of the euro area. This shift in savings can drive down interest rates, which seems to be the case in the Swiss curve. The fact that Denmark's 10-year bond yield is just above 1% is not a function of the two-week CD rate. Back on June 1, Denmark's 10-year bond was yielding 0.95%.
 
Third, low rates may also be a function of deflationary pressure. This seems to be the main factor behind the near zero interest rate policy of the Bank of Japan. As Japanese officials recently point out, in inflation adjusted terms and on a GDP per capita basis, Japan's economy has outperformed within the G10. It is true that the MOF ordered record intervention to stop the appreciation of the yen last year, and the yen's strength is a factor behind Japan's deflation. The near zero interest rate policy has been ineffective in combating the yen's strength and does not seem to be the primary goal of the policy.

What Central Banks Want
There are intended and unintended consequences of policy makers decisions. Some of the unintended consequences may be foreseeable. Typically central banks want to see their currencies move in the same direction as monetary policy. When a central bank is in an easing mode, currency appreciation can blunt or offset the easing of monetary policy.
 
However, this need not be the same as cutting interest rates to drive a currency lower. Intentions matter. The ECB cut its refi rate by 25 bp and lowered the corridor that its trades within by 25 bp as well. This brought the deposit rate to zero. Its goal was to provide more monetary stimulus to the regional economy. A depreciation of the euro was not the goal but a foreseeable and arguably not completely undesirable consequence.

Sterling
At the same time, sterling has generally been firm despite the BOE's decision to expand quantitative easing. Sterling has traded at four-year highs against the euro as recently as yesterday. It has appreciated by about 4.4% this year on a broad trade-weighted measure since the start of the year. It has appreciated a little more than 1% on this metric since the BoE decided to renew its gilt purchases earlier this month.
 
'Currency war' is rather strong rhetoric and a broad brush to characterize what's happening. The rhetoric does not draw a distinction between currencies that are undervalued and those that are overvalued. For example, according to the OECD, the Swiss franc is more than 34% overvalued and the yen is more than 25% undervalued. This is quite different that the undervaluation of many emerging-market currencies. The IMF/OECD estimates that the Brazilian real is 12% undervalued; the Chinese yuan by 54% and the Indian rupee more than 188% undervalued.
 
Lastly, the currency war framework would seem to suggest sharply divergent currency moves as countries press their advantage. Yet, looking at the G10 currencies, the range between the best performer and worst performer in H1 12 was about 6.7%. In H1 11, the range was close to 10.5%.

Issues Likely To Persist
In summary, there are several reasons why countries reduce their interest rates to near zero and why some market rates are below zero. The risk is that those same considerations, which include poor growth prospects, deflation pressures and attempts to neutralize safe-haven demand, drive other countries to reduce interest rates. The global de-leveraging phase and attempts to put fiscal policy on more solid footing warns that these considerations will likely persist.