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Negative Interest and Franc Shock: What Happens Next?

Why do we have negative interest rates in Switzerland? What impact will they have, combined with the strong Swiss franc? In an interview, two Credit Suisse analysts share their opinions. According to the experts, the hardest-hit sectors are tourism, retail, and export, but also banks and pension funds.

Oliver Adler, Head of Economic Research, and Christine Schmid, Head of Global Equity and Credit Research, answer the most important questions on these topics.

What are the fundamental economic factors that can lead to negative interest rates, in Switzerland or elsewhere?

Generally, interest can slide into negative territory for three reasons. The first reason is deflation, i.e. inflation expectations become negative. Instead of the normal positive inflation premium, interest then carries a negative inflation premium. The second reason is investors fleeing from riskier investments (e.g. equities) to safe havens (meaning government bonds). The third reason is investors being pressured by government measures to buy bonds (financial repression).

Which of the three factors is at work now?

Certainly not the second. We've been having an equity boom for several years and investors are becoming increasingly risk-tolerant. The third factor could play a role, even though we do not have explicit government requirements with regard to investments. However, the regulations regarding the risks that pension funds and insurance can take, in combination with extensive purchases of government bonds by central banks, resembles a mild financial repression. The first factor seems to be the most important, for the moment at least.

Does that mean we are in deflation?

Not yet, but there is at least a risk of deflation. The current economic environment is indeed rather deflationary. There are, in turn, several reasons for this. First, following the boom of the 2000s, there is excess capacity in industry almost everywhere in the world, which is putting pressure on prices – China's producer prices have been falling for approximately three years, as are Swiss import prices. There is excess capacity in many commodity sectors as well – the latest oil price developments are an example. Finally, wages in many countries, especially in Europe, have been under pressure since the financial crisis.

Are there other deflationary forces?

Yes. The global financial crisis, the euro crisis, and the financial problems in many emerging markets are forcing debt reduction (deleveraging) after years of credit expansion and debt accumulation. The high levels of debt force savings and therefore reduce the overall economic demand. In addition, there are structural factors that tend to have a deflationary effect, especially demographics. If life expectancy increases while retirement security decreases, people save more; in some countries, the population is decreasing in absolute terms, therefore so is the purchasing power. Finally, deflation is also the result of progress in technology and productivity. Goods can be manufactured at increasingly lower costs – which puts pressure on prices and therefore on interest. Naturally, this is nothing new.

Aren't the central banks, such as the SNB, and their monetary policies responsible for negative interest?

Yes and no. Central banks are generally obliged to achieve at least a slightly positive inflation trend. Most central banks in the developed world have an inflation target of 2 percent. The American Federal Reserve Bank has an explicit target of 2 percent; the European Central Bank (ECB) has an inflation target of "close to 2 percent"; the target of the Swiss National Bank (SNB) is price stability, by which it actually means a slight positive inflation. If the central banks achieve their target, inflation premiums and therefore interest rates should be positive.

Didn't the SNB and other central banks lower their key interest rates into negative territory?

Yes, that's correct – thereby probably also contributing to other parts of the interest curve temporarily sinking even deeper into negative territory. However, if the "reflation policy" of the central banks is successful, the inflation premium should become positive once again and the long-term interest rates should increase. Initial signs of this can already be seen in the announcement of quantitative easing (QE) by the ECB. Short-term rates have become even more negative in the last few weeks while long-term rates have gone up again.

What is the connection between the strength of the franc and the negative interest rates?

The connection is a very direct one. First, the flight to the franc gave rise to revaluation expectations, which are equivalent to deflation expectations, since a constant appreciation of the franc would lead to constantly falling prices, i.e. deflation. Second, the SNB reacted to this development by introducing negative interest at the short end, precisely to fight revaluation and deflation.

Couldn't the SNB have achieved the same objective while maintaining the euro minimum exchange rate?

Yes, it could have. However, it would then have had to "autonomously replicate" the upcoming QE from the ECB, which would have led to further inflation of its balance sheet. Obviously, it wanted to avoid this. As an aside, by revaluating the franc, the SNB has actually expanded the quantity of francs, calculated in foreign currency. Calculated in Swiss francs, however, the monetary policy is naturally more restrictive.

What are the risks of this measure?

The main risk is that, as a result of the revaluation, we will suffer a recession in Switzerland. We are hopeful, however, that this scenario can be avoided – provided the franc does not fall toward parity again. Nonetheless, a significant economic downturn will be hard to avoid. The second risk is that the SNB has paradoxically strengthened revaluation expectations for the franc. At the moment, this risk seems less pressing, but the status of the franc as a "safe-haven" currency has of course been reinforced by the decision of the SNB.

If the revaluation pressure on the franc returns – what other measures could the SNB take?

Essentially, three. It could intervene in the foreign exchange market again, with a new – but at most, implicit – minimum exchange rate for the euro or for a currency basket. Or it could sink the short-term interest even deeper into negative territory. The alternative to this would be to restrict the exemption for banks on their giro accounts even further. Capital controls would be a last resort. Due to the negative impact on the financial market, we do not consider capital controls a suitable instrument.

How long could negative interest last?

Short-term rates are likely to remain negative for quite some time. The SNB is unlikely to be able to raise interest rates before the euro zone achieves a significant economic upturn, inflation there goes up, and the ECB ends its quantitative easing and starts thinking aloud about initial interest hikes itself. This appears rather unlikely for the next two, maybe even three years. The alternative, namely that the Swiss franc will soon depreciate on its own so markedly that the SNB could raise interest again by itself, is even more unlikely. However, as previously mentioned, the long-term rates can rise slightly if revaluation pressure on the franc and therefore fear of deflation decrease a little. Finally, a stronger recovery in the US could lead to a further hike in US interest rates, which could also drive long-term rates in Europe, including Switzerland, up a little. Overall, however, a significant change in interest rates appears unlikely in the long term.

What is the impact of the franc revaluation on the Swiss economy and various sectors?

As mentioned, an economic downturn will be hard to avoid. Nonetheless, various sectors of the economy are affected in very different ways, at least initially. Sectors that mainly sell and produce domestically (e.g. telecoms) are barely affected. In contrast, our export-oriented industries and sectors are directly affected and facing strong competition from the import sector. The shock is having a strongly negative impact on tourism and retail (via shopping tourism). Parts of the MEM industry (Machine, Electric, and Metal) that were already under a lot of pressure due to foreign competitors these past years, despite the euro minimum exchange rate, are also negatively affected. Pharmaceuticals and specialty chemicals, where demand does not react so strongly to price changes, and which do have a high export share but rather low domestic costs and various production sites, are much less affected. The impact is more strongly felt in the watch industry and the financial industry. Strongly negative macroeconomic consequences would only arise if employment were to suffer more. We hope that this can be avoided.

What is the impact of the franc revaluation on banks and other asset managers?

The franc revaluation leads to a one-time profit decline for internationally-oriented asset managers and banks, including Credit Suisse, due to the high share of domestic costs and the lower (when calculated in francs) commission income. The assets under management reported in Swiss francs decrease, leading to a significant decrease in commission income. This one-time degradation of results is compounded by increased regulatory costs. This exacerbates existential problems, especially for smaller providers, and will likely reinforce the trend toward consolidation in private banking.

What challenges does negative interest present for banks?

In principle, banks can live with negative interest, but there can be technical problems. First, as a rule, as long as the interest received (e.g. interest on loans) exceeds the interest paid, meaning that the interest margin is positive, a profit can be made in traditional banking business – even if the interest is negative. As mentioned, the long-term rates now clearly exceed the (very negative) short-term rates.

What are the technical challenges for banks?

Because clients are requesting increasingly long durations due to the record-low interest, especially in the mortgage sector, this increases the bank's interest rate risk. However, this must be hedged in matching maturities, which incurs costs in the current environment.

What is the impact of negative interest on mortgage rates?

The risk premiums for clients depend on the specific client risk on the one hand, and the hedging costs for the banks on the other hand. Due to the more difficult situation in hedging, the long-term mortgage rates have therefore slightly increased recently. A more significant increase could only be expected if there were a change in interest (which we do not expect at present) or if the credit quality were to decrease throughout the mortgage market, e.g. due to a recession. We do not anticipate this either, for the time being.

Can we expect negative interest on savings?

The majority of Swiss banks are now covering costs associated with new deposits from institutional clients; corporate clients and financial services companies pay fees on high cash positions. So far, retail clients have not been charged negative interest or fees. If the SNB becomes obliged to lower interest again or further limit the exemption, negative interest cannot be excluded for retail client accounts either, most likely with a certain exemption here as well.

In case of negative interest, wouldn't clients withdraw money and place their cash in safes?

If interest rates were to become strongly negative, it would indeed be expected that households would increase their cash assets. At the moment, the interest rates (opportunity costs) are not yet negative enough. The costs of holding large amounts in cash are considerable. Would insurance cover such high amounts, for instance? Not likely. If, however, a "run" for cash were indeed to take place, the SNB would have to either put many more notes in circulation, e.g. through loans to banks, or – in the most extreme case – restrict the holding of notes by emergency measure. This is of course a very unlikely scenario.

What is the impact of negative interest on insurance companies and pension funds?

Life insurance companies and pension funds, both of which traditionally rely strongly on fixed-income investments, are facing problems. In light of their risk profile and the investment guidelines (BVG), it will be difficult for these investors to increase their share in riskier investments such as equities or high-yield bonds. In the case of high-yield bonds, another problem is that foreign currency investments are dominant, incurring currency hedging costs that have significantly increased due to negative interest in Switzerland.

What would be the longer-term impact for pension funds?

If negative interest were maintained in the longer term, this would contribute – with the given investment strategy – to an underfunding trend in pension funds. Therefore, negative interest makes it appear even more urgent to initiate reforms of social services and pension funds. In periods of negative interest rates, it seems increasingly absurd to let politics determine minimum interest and conversion rates.

What is the impact of negative interest (and the franc shock) on the real estate sector?

There are various impact mechanisms here as well. The even lower interest and the investment crisis in Switzerland should in principle bolster demand for real estate. Especially on the part of institutional investors such as pension funds and insurance companies, one should expect an increase in demand for real estate investment, since – for the time being – the returns still look attractive compared to bonds with good credit ratings. In the long term, the risk of overproduction of real estate in Switzerland would then rise, potentially leading to rising vacancies, falling rents and, ultimately, higher loan defaults. Real estate yields would then gradually sink to the lower interest rates. The franc shock has two effects. First, the foreign demand for Swiss real estate will likely sink, quite simply because it has become more expensive in foreign currency. Second, by making the economy weaker, the franc shock also weakens the demand for real estate. This offsets the impact of lower interest rates, at least to some extent.

What does the interest and franc shock mean for Swiss equities?

After an initial overreaction, Swiss equities have for the most part recovered. Not least, equities are thereby replicating the recovery of the euro against the Swiss franc. The machinery industry, the watch industry, and the financial industry are the sectors most affected. Many companies have announced and already initiated cost reductions and outsourcing abroad. This should partially compensate the anticipated decline in profits and has significantly contributed to the recovery of the assets.