Maybe not truly natural, as this is a matter of currency intervention, but close.
First a little context. As previously mentioned, Denmark’s currency, DKK, is allowed to trade within the ERM-II band. In reality, however, Nationalbanken has preferred a much tighter band. Historically, the Danish lending rate was a little higher than the ECB rate to incentivise investors to move into Denmark. That has changed. Graphed it looks like this, courtesy of Danske Bank:
So it is in the context of keeping with the currency peg that Denmark, as of Thursday, became the natural experiment for negative rates.
Denmark is an attractive destination to park money for two reasons. It is a safe haven with no currency risk to the euro, and it is a cheap hedge against a euro break-up because there is no FX penalty if nothing happens. Here is Tina Mortensen from Citi with a recap:
Following the ECB’s 25bp rate cut, the [Danish central bank] yesterday cut the lending rate, discount rate and CD rate by 25bp. The new rates are 0.2% for the lending rate, zero for the discount rate, and minus 0.2% for the CD rate. The [Danish central bank] raised the ceiling for current account deposits from DKK 23.2bn to DKK 69.7bn, hence limiting the extent to which the negative CD rate (which applies to deposits above the ceiling) bites. Nevertheless, in aggregate the banking sector will still have sizeable excess deposits at the CD rate, and this is the first time in Danish history that an official interest rate has gone negative: the [Danish central bank] has entered uncharted territory.
The CD rate is the return financial institutions get on deposits at the central bank with maturity up to seven days.
Governor of the central bank, Nils Bernstein, told Danish media that the costs to banks would amount to “a couple of hundred million DKK.” The Danish Banking Association came out with DKK 300 million (although what possible motive would they have to exaggerate… right?).
As we have noted before, at this point the lending rate is not the most important rate — the deposit rate is. We have in effect just got our first illustration of what a negative deposit rate means. Remember, yields have been negative for some time now, but banks have always been able to arbitrage the difference between firms placing money at no or negative yields in banks, after which banks will earn the spread to the deposit rate.
Can banks survive in this environment? It is a good question. Like the ECB, Nationalbanken’s motive is to move money into riskier assets. Unlike the ECB, however, the motive is to stop capital inflows into Denmark. So this is more of a Swiss-style situation.
One question that is worth asking: why should this stop the inflow? Foreign money is not likely to come in the form of deposits at banks, but rather buying of government bonds or safe covered bonds. In fact, this will likely push yields down further as depositors move money out of banks and into bonds, assuming commercial banks lower deposit rates below 0 %. Whether this will be enough to stop inflows (or cause outflows) has yet to be seen. If the negative yields on safe haven bonds are anything to go by, it won’t.
Here’s Danske Bank with the effect on money market funds and the repo rate:
The cut in the CD rate to -0.20% lowered the entire DKK OIS (Cita) forward curve but in particular the front end. The market reaction was similar to the one seen in EUR OIS (Eonia), implying relatively unchanged Cita/Eonia spreads. This is exactly what the NB wanted, as this is no time to introduce a positive carry on the krone.
Looking further ahead, we see a probability of further Danish rate cuts. This leaves further downside potential for Danish Cibor fixings. However, as long as the Danish repo rate stays positive we expect 3M Cibor fixings to be floored around 0.15-0.20% – based on the assumption of the repo rate being floored at 0.05%.
So how big effect will this have on inflows? Time will tell. What it will affect, though, is bank profitability and the ability of money market funds to seek out yields in Denmark. If this is a problem in the euro zone, we don’t know what to call it in Denmark.
Given that the euro zone crisis is not easily solvable (doh) and that the peg is likely to stay in place, this might be a lengthy experiment. We can add the Danish negative deposits to Sweden‘s in 2009 and the Swiss floor.
Apart from negative deposit rates, Denmark’s FX reserves have risen quite a bit in another sign of capital inflow; something Denmark is clearly uncomfortable with, just like Switzerland. From Nationalbanken’s latest report out Tuesday:
In June, Danmarks Nationalbank’s net purchase of foreign exchange due to intervention in the foreign-exchange market amounted to DKK 7.3 billion.
It’s not enough. Citi’s forecast, for example, are:
Our base case is for the [Danish central bank] to cut the lending rate (currently 0.2%) to zero and then probably also into negative territory by yearend.
Land of zeros and negative rates — principal destruction de jour. How long before the 10-year yield goes negative?
– By Simon Hinrichsen and Izabella Kaminska
Bankers watch as Sweden goes negative – the FT (2009)
Money market funds close after ECB cut – the FT
Negativity at the door, euro money market fund edition – FT Alphaville