Top of the Street

Wall Street, the Federal Reserve and others produce a constant flow of research and opinion. Some of the best recent efforts:

From ZLB to ELB
David Mericle and Karen Reichgott, Goldman Sachs
26 February 2016

Investors seem vaguely confident that the US will avoid negative interest rates, but that hasn’t stopped a new round of speculation over the possibility in the US. Deutsche Bank, Goldman Sachs and JPMorgan all weighed in on the topic last week, with Mericle and Reichgott offering the most reasoned review. They conclude that US policy rates could stray to between -0.5% and -2.0%.

The authors establish their consensus bonafides by arguing that the US would see negative policy rates only if the US fell into recession and the Fed exhausted forward guidance, ZIRP and more QE. Once the authors make the point that they do not expect negative rates, they become free to paint a picture of the new regime.

Denmark, the euro zone, Sweden, Switzerland and Japan have all have tried negative rates and have gone much further with it than most expected. No one has seen cash hoarding. Deposit rates have dropped, although retail rates have been sticky at zero. Lending rates have dropped, too. In countries that wanted to keep foreign exchange pegs in place or depreciate the currency, negative rates have worked, too, perhaps with the temporary exception of Japan.

Not all negative interest rate policies, or NIRP, have been equal. Denmark and Japan have used a tiered system where some deposits are exempt from negative rates. The ECB has not used tiers.

According to Mericle and Reichgott , experience has taught a few lessons: (i) policy rates can go more negative than the Fed once thought, (ii) retail deposit rates get sticky around zero, perhaps out of fear of sending that cash out to find the nearest mattress but nevertheless imposing costs on banks and (iii) tiered negative policy rates can take pressure off bank profits and allow monetary policy to still work.

The authors worry that negative policy rates in the US could punish bank profitability if retail deposit rates effectively get floored at zero. The resulting losses could tighten bank lending, possibly the first case of irony in monetary policy. European and Japanese banks have sharply underperformed their US brethren, and the authors wonder if negative rates outside the US might be to blame.

Mericle and Reichgott also worry about money market funds – a $2.5 trillion industry in the US, not to mention another $1 trillion in similar vehicles such as ultra-short bond funds. Negative rates imply that a $1 deposit in a fund returns less than $1, breaking the buck. A tiered approach to NIRP that left bank retail deposits floored at zero could drain money market funds. Since money market funds buy so much commercial paper, a flight to banks could tighten credit to corporations. Irony again!

As an aside, Alex Roever at JP Morgan has argued that money market funds could reengineer themselves to still offer a stable NAV by redeeming less than $1 in shares for every $1 deposited. Nice optics. Maybe that’s enough. The economics of negative rates, however, would not change.

The flurry of Street speculation about negative rates may have been prompted by Fed Vice Chair Fischer’s recent remark that the experience in Japan hasn’t been so bad. Everyone is suddenly taking this much more seriously.

Stepping off from the Fed staff estimate that the cost to store cash in the US runs around 35 bp, Mericle and Reichgott conclude that rates in the US could go as low as -0.5% to -2%, depending on the amount of bank deposits exempt from paying the penalty.

In depth look at subordinate auto loan ABS
Amy Sze and Christina Wong, JPMorgan
26 February 2016

Liquidity in any asset is always hard to pin down, but that makes any effort to do it interesting. This piece starts with a quick tour of projected losses in prime and subprime auto ABS but gets interesting when it goes beyond models and turns to liquidity, albeit historic. The authors tracked 167 BBB and BB auto ABS classes from mid-August 2015 through February 2016 and found trading in only 89 of them, with the averaged traded class trading eight times. For the average class among the 167, that’s one trade every 42 days. The analysts note that many of these classes were retained by their issuers and never traded. Still, the piece traces the apparently infrequent process of price discovery in this corner of the market. It’s a reminder that in an increasing span of the fixed income markets, the fastest growing component of compensation is for liquidity risk.

SEC proposes liquidity rules on mutual funds and ETFs: CMBS market impact limited
Chong C. Sin and Munier A. Salem, JPMorgan
26 February 2016

Although the SEC proposed new liquidity rules for mutual funds and ETFs last September and closed its comment period in January, this piece shows that the market is still trying to decipher the potential impact on assets as well as on the funds. The most useful contribution in this note is the summary of the liquidity categories that funds will need to use in describing their investments, the criteria for judging liquidity and their ability to use swing pricing in cash shareholders out of the fund – in other words, charging shareholders more when the cost of liquidating assets rises. Using one measure, the analysts show CMBS generally is not especially liquid. Not surprisingly, they qualify their finding by arguing that highly rated positions in some deals should be much more liquid than the average CMBS. The analysis of CMBS liquidity is okay, but more useful is the general reminder that the new rules are in the pipeline and that fund liquidity will almost certainly rise.