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Tutorial Negative Interest Rates – How It All Works

By Louis Holding-Parsons on October 30, 2019

5 (100%) 1 vote[s]

Negative interest rates was considered so unlikely that some banks cannot handle it. Although “computer says no” may sound funny, the reduction in interest rates to a level where you are paying the bank to keep your money is becoming increasing reality. Within the Western world, some major currencies such as the Euro and Swiss Francs are already yielding negative interest. Question is how did we get here and what caused it?

What are negative interest rates?

Euro has a negative interest rateIn short, it means you are losing money whenever you place it somewhere. Most people when placing money in a bank account or buying an asset, expect some form of return. The fact that you may end up paying money just to get your money back later, goes against the capitalist approach the Western world is based on: namely to grow. Currently if you place money in a Euro bank account, you will be (theoretically) deducted -0.50% and deducted -0.75% in a Swiss Franc bank account.

Most banks have chosen not to pass this cost on as it would be bad business. Separately, government bonds for safer economies (such as Germany) which are priced off interest rates are also yielding negative interest, you are paying the German government to look after your money!

How did this happen?

Negative interest rates are partly caused by massive buying of bondsAs a result of the 2008 financial crash and the resultant disappearance in growth, central banks stepped in to provide growth through the creation of money. This was achieved by introducing quantative easing: the buying of assets by central banks. Central banks chose to buy bonds, especially government ones. These ”new entrants” into the market, led to the price of bonds increasing exponentially as central banks around the world bought bonds. As one can imagine if a new buyer enters the arena who is prepared to do ‘whatever it takes‘ to achieve their aim, prices will move strongly.

As the yield on bonds moves inversely to their price, the higher the increase in the price of bonds, the lower the yield. Eventually if this buying is sustained, the price of bonds get so high that the yield reduces to zero, and keeps going into eventually becoming a negative yield.

So why not avoid buying negative yields?

The desire to seek protection has contributed to negative interest ratesThe problem here is some buyers choices are limited. Pension funds and institutional investors who have large amounts of cash to invest, are not keen on holding cash for too long. Cash is only as safe as the bank which holds it. As the 2008 financial crisis showed, they can easily go bankrupt, better to park your money in a German government bond. German prudence and fiscal discipline makes them the favoured choice of anyone seeking to avoid risk.

With the ECB crowding out the bond market with it’s quantative easing programme, those seeking ultra safe German bonds have found there are less to go around. This has caused their yield to be depressed into being negative yielding as their price increases. It seems it is a one way bet. With political instability and increased trade wars increasing the threat of a recession, even losing a small amount of amount to negative interest rates is seen as preferable to depositing money in a bank account.

Is it possible to make money from negative interest rates?

You can make money from negative interest ratesSome institutional traders probably already have, but not in a typical manner. Retail forex traders can learn from this kind of expansive thinking. It is entirely possible to make money by accepting to lose some yield through negative interest rates, whilst gaining it through Forex trading. Any canny trader who had sold GBP in early 2016 (to hedge his bets of a Brexit yes vote) and bought EUR pre the Brexit referendum, would currently be sitting on approximately 20% currency gain (see chart above).

As seen above, holding large amounts of cash is not an option for some, but buying German 10 year government bonds (considered the safest in the world) would be. By accepting to lose some yield, (the German 10 year government bond turned negative for a period shortly after the vote) to ensure your money is held in a safe asset you are able to make a Forex gain.

Conclusion

Negative interest rates are a product of our time. It is not something anyone had thought of to prepare for. The jury is still out if quantative easing is a good idea. There is an argument that it has distorted the market and raised some long-term questions: How do we invest our pensions in retirement now that bonds are yielding next to nothing? As a forex trader, your preoccupation should be to analyse these developments, stay flexible whilst maintaining discipline and taking advantage of situations to profit from them!

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Louis Holding-Parsons

Louis is a portfolio manager and a trader who brings a wealth of experience in private banking to The Lazy Trader. A fundamentalist and a trouble-shooter, Louis makes a firm contribution to the trading team.

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Louis Holding-Parsons

Louis is a portfolio manager and a trader who brings a wealth of experience in private banking to The Lazy Trader. A fundamentalist and a trouble-shooter, Louis makes a firm contribution to the trading team.

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