The most beautiful arbitrage of all time?

2016-02-02 11am EDT  |  #US dollar #FOMC #Federal Reserve #bonds #gold

First it was the ECB. They were then followed by a host of other independent European countries like Switzerland and Sweden. Now it is Japan’s turn. One by one, large developed economies have adopted negative interest rate policies. What used to be unimaginable has now become strangely routine.

Even NIRP skeptic Federal Reserve Vice Chairman Stanley Fischer admitted yesterday during a Bloomberg interview that negative rates were “working better than I expected in 2012.”

So there we have it. Mario Draghi broke the taboo of negative rates and the world didn’t fall apart, so now we have a whole host of countries following him down this road of stealth competitive devaluation.


The most beautiful arbitrage of all time?

Instead of arguing about the efficacy or morality of negative rates, I am putting on my trader’s hat and will just point out these Central Bankers are creating what could be the most beautiful arbitrage of all time.

Let’s just imagine you are a commercial bank that has access to the Central Bank lending facility. You are in essence being paid to borrow money. Instead of having to pay back your principal along with interest, the Central Bank is letting you pay back less than you borrowed.

I know it sounds crazy, but that’s the reality of the situation. That’s what negative rates mean. You get paid to borrow.

You might say to yourself why don’t the banks borrow at negative rates and then invest the money in risk free t-bills? That answer is easy - t-bills and other risk free instruments are also trading with negative rates. The fixed income market gets arbitraged to death by traders looking to exploit inefficiencies along the yield curve. It is not that easy to simply borrow at negative rates and find a safe asset that is yielding nothing… Or is it?

What asset is backed by the government, yet yields nothing?

Cash is king

It is not practical, but theoretically there is nothing stopping a commercial bank from asking the Central Bank for piles of cash instead of negative yielding t-bills. And if the Central Bank wouldn’t allow the direct creation of that much currency, it could be accumulated through regular business dealings. When a bank accumulates a certain amount of cash they usually send it to the Central Bank. Instead the commercial bank could hoard cash and simply never return it. After all, it is backed by the government, and yet has a higher yield than overnight rates.

Taken to its extreme, let’s imagine rates went deeply negative. They are already lower than -1.00% in Switzerland for a two year term, so it’s not outside the realm of possibility that they double again. So let’s assume a negative 2% rate in Switzerland.

Now let’s assume a Swiss bank borrows one billion Francs for two years at a negative 2% rate. That means the bank will pay back the same principal two years later, but in the mean time, they will earn 20 million Francs per year.

Obviously currency can be stolen, so you can’t just stuff all this currency in the office safe. You need a secure vault. But I am sure most Swiss banks already have Doctor No style vaults buried deep in the mountains.

Take the billion Francs, hire a few more guards, and pocket the 40 million Francs. And the good news about this arbitrage? It’s scalable. If you are going to do one billion, why not two or five?

The other no yield currency

Obviously this example is a little tongue in cheek. Even Goldman Sachs would have ethical qualms asking the Central Bank for billions of dollars of currency so they can arbitrage negative rates versus cash. But I think it is an important thought exercise. As the world descends into negative interest rates, we should expect more and more accumulation of cash.

Right now the world is obsessed with US dollars because the Federal Reserve is insistent on following through with their relatively hawkish monetary policy. But eventually the US economy will roll over, and they too will follow the rest of the world lower into negative rates.

Influential policy setters like Stanley Fischer choose their words carefully. Yesterday’s admission negative rates have worked better than Fischer previously predicted, should be viewed a big shot across the bow for negative rates in America. There were already a lot of doubters within the FOMC about the efficacy of the second and third round of QE, so during the next downturn we should expect something different. Negative rates would be a logical next step.

When it finally becomes obvious even to the knobs running the Federal Reserve that they have tightened into a recession, the Federal Reserve will follow the rest of the developed world into the land of negative rates.

When that happens, there will be no currency that is safe. All countries will be trying to devalue against each other. Rates will be negative across the board, and there will be few places to hide.

I wish there was some sort of currency that was no one’s obligation and couldn’t be debased. This currency would have no yield, and would be easy to store vast quantity of wealth in a small area. Ideally it will have been accepted as a store of value for thousands of years. In an environment of negative rates, the demand for this type of currency would sky rocket. Man, I just wish I could think of something like that…

Thanks for reading,
Kevin Muir
the MacroTourist