Given the speculation that the ECB could announce negative interest rates on Thursday, Ken Dickson, Investment Director, Standard Life Investments, investigates the impact of both negative nominal and real rates on currencies.
Cases of negative nominal interest rates are rare
Recently, there have been suggestions that the ECB could adopt negative interest rates as the next move to support the European economy and ward off the deflation “ogre”. Despite much academic debate on the subject, in fact there have only been four widely recognised cases (See Chart below), namely Japan, Sweden and also Denmark and Switzerland where negative interest rates remain in force at the present time.
The impact on currencies is not uniform.
In theory, the implications for currency markets can be serious, as negative interest rates act like a tax, gradually eating into capital. This implies that investors with choice should move money into a currency with a better return. In practice, it is clear that there is no uniform currency reaction to a move to negative nominal interest rates. The impact depends on the circumstances surrounding the decision at that time. Only in Japan’s case do we find the conventional reaction. In the case of Denmark and Switzerland, the authorities already had a currency peg in place and therefore their currencies were unable to move significantly. In the Swedish example the currency market was deep in the midst of the Eurozone crisis and the capital loss from the tax effect was not anywhere near enough to offset the risk of capital depreciation in competitor currencies like the euro.
Negative Real Interest rates have a more consistent impact
Of course, an investor’s capital can also be impaired when inflation in a country is above the level of interest rates, creating negative real interest rates, as this erodes the investor’s effective purchasing power. Not only is the incidence of negative real rates more prominent but the effect on the currency market is more consistent. We find that for the Japanese Yen in the late 1990s, and also since May 2012, for the British pound since 2009 and for the US dollar during the period between July 2002 and May 2005, there was a strong correlation between negative interest rates and a sharply weaker currency. The average depreciation of these cases was 16% over an average 26 month period.
Risk appetite and safe haven effects are also significant
However, negative real interest rates do not always drag a currency lower. Global factors like risk aversion, particularly in relation to the nature of the risk, also seem to play a role. In the US, firstly in 2008 and then since the end of 2009, negative real rates have co-existed with an appreciating dollar. This reflects the perceived global nature of the economic risk at the time and the US dollar’s role as the most important safe haven. A similar effect explains the Swiss Franc’s 23% appreciation between 2002 and 2005. The Euro also has had two periods of negative real interest rates and in both these periods the Euro appreciated. The first instance, between autumn 2003 and March 2006, was during a period of significant US dollar weakness, when the US also had negative real interest rates and when central bank managers diversified some of their currency reserves towards European currencies. But the second occasion (March 2010 until the present) is a period when European economic growth is underperforming, inflation is trending lower and the peripheral debt issue remains an on-going problem. The Euro’s appreciation is only 1.6% in this second period whereas it was 10.3% in the first, hinting that the reaction function is markedly different when the issues are more domestically oriented.
Will negative rates weaken the Euro?
Although the evidence is mixed there are clues for the likely impact of future negative rates for currencies. If domestic economic weakness is the main reason for interest rates being below zero, or if the predominant market risk factor relates to that country alone, then the currency impact from negative rates is likely to be more potent. Even though few countries in 2014 will be easing monetary policy the key differences will be the likely US tapering and the implied divergence in EU-US monetary policy trends. Whilst the Euro clearly has some safe haven characteristics, a move to negative nominal and real interest rates directed specifically to deal with economic problems in the Eurozone is quite likely to drive the Euro lower. Our portfolios continue to prefer the US dollar to the European currency throughout 2014.
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