Swiss ‘capital preservation’ | FT Alphaville

Swiss ‘capital preservation’

FT Alphaville has already talked about the risks associated with a government bond turning into a bit of a Giffen good. (Great Depression, ahem.)

A Giffen good is essentially one in which the traditional laws of supply and demand do not apply because there is no viable substitution option.

It’s one of the factors blamed for turning a financial crash into a growth-busting deflationary spiral in the 1930s.

But investors’ obsession with ‘capital preservation’ also played a significant role. It’s the sort of capital preservation obsession which, by the way,  is now arguably being unleashed in Switzerland.

For example, we posed the following two questions regarding the Swiss bank’s recent liquidity actions and its sight deposits to Marc Ostwald at Monument Securities (based on that above assumption):

1) Does that mean there is no floor on rates in Switzerland (because sight deposits are not interest bearing)? In the US they use IOER as a floor mechanism?

2)Wouldn’t a zero rate at sight encourage banks to hoard Swiss francs at the central bank? Why lend them out for a negative rate, when you can keep them on reserve for free? Wouldn’t an increase in sight deposits thus weirdly end up contracting the wider money supply? Or is this negated by the fact that negative interest rates would encourage foreign held Swiss francs to flow back into Switzerland?

Here were his thoughts (our emphasis):

1) In principle there is no floor unless the SNB makes the policy choice to pay interest, which it clearly does not want to do now. It is certainly possible to argue that if sentiment becomes so distressed, then end investors are not thinking about capital preservation and thus seek out safe haven, but about having their capital returned, in which case the return ON their capital is rendered irrelevant, and they are only looking at the return OF their capital, i.e. the only perspective is one about counterparty risk, and nothing else.

As for the US, the IOER payment ability is of course relatively new, but as (rightly) discussed into the ground on Zerohedge in recent months, the critical aspect is the fall-out for the repo market, as per: the repo market has a number of essential functions. Chief among them is its mechanism to cover short positions in fixed income securities. If the special collateral rate is negative, then moneylenders that are short on UST positions cannot find enough physical bonds to cover them. Shortage of this magnitude is often a function of hypothecation.

The answer to the counter-intuitive question of why someone would lend money at negative interest rates is that the moneylender’s first priority is to cover that short position. As the special rate deepens in the negative or persists there for a period of time, the pressure on the moneylender to cover grows exponentially.

The longer the negative interest penalty for being short remains, the more pressure there is to exit the short position. It is a self-reinforcing feedback loop since the short covering forces prices higher, leading to more losses for holding short positions, etc. and that is of course what the Fed is in effect trying to achieve by forcing shorts out of the market, and final investors further up the curve.

2) Yes, unless the SNB resorts to 1970s tactics of negative rates then there is that risk, though as with 1) above, counterparty risk could steamroller normal commercial considerations.

As for money supply considerations eminently this does in theory and practice mean less money being committed to longer-term securities (bonds, equities, fund investments, even property), and thus a bloating of narrow MO type measures and a decline in M3 type measures.

Negated by repatriation? Only if repatriated funds are being invested in longer-term or risky type assets, or indeed offered out as loans locally (which is in principle the same thing; if not then it merely pressures local money rates even more.

Of rather more importance though is less the implications for money supply, but enormous misallocations of capital within the economy (local, regional, global).

And in principle one then moves onto the grim reaper subject of history’s hard lesson, once all the economic policy options appear to have been exhausted (and it is as much about perceptions as about the demonstrable truth that all options have been exhausted), then the military option has always generally been exercised.

Of course, Switzerland does have one major advantage when it comes to dealing with Giffen good-style bonds and capital preservation obsessions. It happens also to be the key reason why Switzerland can get away with not instituting floor mechanisms, while countries like the United States and Britain can’t.

Switzerland does not lack creditworthy borrowers to the same degree other countries do.

Therefore there is a very great possibility that when faced with the prospect of earning zero in sight deposits, or receiving a negative interest rate on money held in government bonds or bills, banks will opt to lend to the market instead — thus greatly increasing the money supply after all.

In that case, QE is no longer deflationary — even in a giffen-good scenario.

Related links:
When a government bond becomes a Giffen good
– FT Alphaville
Le plan, negatifs taux d’intérêt
– FT Alphaville
Negative interest in cash, or goodbye banknotes
– FT Alphaville