When a government bond becomes a Giffen good

So, Swiss short-term market rates are now fully negative:

But it’s not just short-term rates. As of Thursday anyone holding two-year or three-year Swiss bonds is apparently demanding that the price exceeds the coupon-included return in order to be tempted to sell. Bidders, meanwhile, are still not prepared to pay over the face-value of the bonds.

Liquidity wise, this could pose a bit of a standoff.

What does this mean for anyone holding Swiss franc goverment bonds? Well, it might suggest the concern is now about capital preservation, because of deflationary forces being hard at work.

It’s important to stress that what the Swiss National Bank is doing is tantamount to quantitative easing. It is, to use popular parlance, “printing money” to flood liquidity into the system. But, unlike the moves of other central banks, the liquidity it is injecting is not being sterilised. In fact, there are no sterilisation mechanisms being deployed whatsoever. Not even a “floor” strategy.

This isunique.

  • The ECB sterilises via the deposit facilities it offers to the market (at a repo rate return). This also sets a floor for rates.
  • While the BoE doesn’t outwardly sterilise its quantitative easing operations, it does offer the Bank rate on its reserves, which again sets a type of floor.
  • The Fed, meanwhile — contrary to popular belief — also partially sterilises its “money printing” operations, via the interest on excess reserves policy (IOER). IOER is simply another example of a floor mechanism, designed to keep rates supported.

(*It’s worth noting that since April IOER’s floor power has been diminshed because of the FDIC imposed bank fee on deposits, something which has caused all sorts of repo-market mayhem, It’s also why we’ve seen the Fed Funds effective rate trading a whole lot lower.)

Now, given the Swiss National Bank is not offering any floor mechanism — nor is it sterilising any of its “money printing” activities — what exactly does it mean to accomplish?

It’s difficult to say.

While the huge buildup in sight deposits will undoubtedly cause Swiss rates to fall sharply (the buildup of reserves is used as a rate-targeting mechanism, based on the theory that the more reserves banks hold, the less they require to borrow from each other, and the lower the rate falls), it could ironically also end up killing liquidity.

Since the SNB pays zero on its sight deposits, there is a very real risk banks might be encouraged to hoard cash on deposit rather than to lend it out for a negative rate. This would be the exact opposite of expanding the money supply. It might even be contractionary.

Now, the SNB is probably hoping that the extreme unattractiveness of having to pay an additional rate to hold Swiss francs will be enough to encourage holders of the currency (especially those abroad) to sell the franc and move elsewhere. This, theoretically, should flood the market with Swiss francs, lowering exchange rates and easing liquidity.

But there is still the danger that the move could drive Swiss francs straight into the coffers of Swiss-based banks , who would then be unwilling to lend them out at a negative rate.

In that circumstance, a deflationary spiral motivated by ‘capital preservation’ could begin.

Once that starts, no matter how much ‘QE’ money is printed, it becomes completely ineffective at boosting the money supply. In fact, if anything, it arguably becomes a deflationary force because the money is being pumped directly into a liquidity trap, in which capital preservation (rather than yield) is the chief priority of banks and depositors.

Echoes of ‘Nonmonetary Effects of the Financial Crisis in the propagation of the Great Depression’

Which, by the way, happens to be exactly what happened during the Great Depression.

Don’t take it from us, take it from Ben Bernanke.

The Fed chairman’s magnum opus on the Great Depression ‘Nonmonetary effects of the financial crisis in the propogation of the Great Depression‘ clearly states that one of the key factors that contributed to turning a financial crash into a depression was nothing other than the market’s newfound obsession with holding the most liquid securities (in that case US Treasuries) and nothing else.

In fact, just like today, the market for unsecured lending died a death because counterparties no longer trusted eachother. Everyone turned towards a collaterised lending regime, one in which only the very best collateral (Treasuries and gold) would do. This had the effect of causing a run towards Treasury securities.

What’s more, no matter how much money was printed by the Fed to ease liquidity concerns it only intensified the obsession with capital preservation. Largely by eliminating the number of Treasury securities in the market. Since, there was noone the banks could lend money to in the wider market due to credit concerns, Treasuries became a bit of a Giffen good. The money had to be parked somewhere.

As Bernanke wrote:

“The perception that the banking crises and the associated scrambles for liquidity exerted a deflationary force on bank credit was shared by writers of the times. A 1932 National Industrial Conference Board survey of credit conditions reported that “During 1930, the shrinkage of commercial loans no more than reflected business recession. During 1931 and the first half of 1932 (the preiod stuided), it unquestionably represented pressure by banks on customers for repayment of loans and refusal by banks to grant new loans.”

A device which makes the cost advantage of the simpler approach even greater is the use of collateral. If the borrower has wealth that can be attached by the bank in the event of nonpayment, the bank’s risk is low. Moreover, the threat of loss of collateral provides the right incentives for borrowers to use loans only for profitable projects. Thus, the combination of collateral and simple loan contracts helps to create a low effective (costo of credit intervention) CCI. A useful way to think of the 1930-33 debt crisis is as the progressive erosion of borrower’s collateral relative to debt burdens. As the representative borrower became more and more insolvent, banks (and other lenders as well) faced a dilemma. Simple, noncontingent loans faced increaskingly higher risks of default: yet a return to the more complex type of contract involved many other costs. Either way, debtor insolvency necessarily raised the CCI.

With capital preservation becoming the top priority for banks, institutions were willing to pay more than the face value of Treasury securities, because investing elsewhere would come with too great a risk of default.

And, yes, the downward spiral really did begin with the trend towards a collateralised lending regime.

So is the SNB taking a risk? Yes. Arguably it is.

Is the Fed concerned about similar issues? Yes, possibly.

In which case traders should really re-evaluate how they interpret QE. After all, it’s very possible the Fed decided not to implement more QE exactly because of fears that Treasuries were once again becoming Giffen goods.

Related links:
Le plan, negatifs taux d’intérêt – FT Alphaville
Negative interest in cash, or goodbye banknotes
- FT Alphaville
Better the quality collateral you know?
- FT Alphaville
The perils of releasing the repo rate
– FT Alphaville

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