Cumberland Advisors Market Commentary – NIRP, Lagarde, Trump, Dickens & Holidays

Author: David R. Kotok, Post Date: November 25, 2019

Negative-interest-rate policies (NIRP) have been criticized by some (me included) and pursued by others, including Europeans aligned with former European Central Bank (ECB) president Mario Draghi. However, growing numbers of Europeans are becoming disenchanted with NIRP, and some are now shifting away from it.

Market Commentary - Cumberland Advisors - NIRP (David Kotok)

In our view, negative rates have, predictably, damaged growth for over five years. The ECB’s new president, Christine Lagarde, seems to understand that she faces a daunting task in extricating ECB policy from reliance upon negative rates.

Here is an excerpt from her first speech:

“In my view, since our challenges are common ones, we must meet them with a common response. This involves moving towards a new European policy mix, which has a number of key elements. The first is monetary policy, which I start with because it is my area of responsibility and which will undergo a strategic review due to begin in the near future.”

Hat tip to Kevin Humphreys for the reference. Kevin is manager, European money markets, for BGC Partners. He is based in London. Kevin has kindly given us permission to share his observations with our readers. We completely agree with his view.

“Having had a few references of late from board members to potential side-effects of European Central Bank monetary policy, it was perhaps of little surprise that the ECB in their financial stability report should highlight that sub-zero interest rates have forced large investors to take on more risks and businesses to take on more debt. Equally unremarkable were the other two main observations, that bank profitability prospects have weakened and that mispriced assets may represent a vulnerability.

“What is remarkable is that the ECB seemingly deem that this has all happened independently of their actions, that while they are guardians of the Eurosystem and all that operate within it, they are mere observers. Hold up! What about the 1,988 days since they took EA rates negative (in the form of the short-date steering Deposit Facility rate)? Since then we have dropped a further 50 basis points, the Eurosystem liquidity excess has swollen from €116billion to €1.764 trillion due to outright asset purchases and other schemes, with only minimal relief for banks arriving recently, coming in the shape of excess reserve balance tiering introduced on October 30th.

“So are these 4 identified key risks in the report really some random confluence of factors? No! Not in the slightest! All of these factors and risks are a direct consequence of ECB policy actions.

“One aspect of the beginning of the tenure of Mrs. Christine Lagarde as president of the European Central Bank has been the assumption that her significant political skills will be deployed to bring together governing council members who are assumed to be somehow fragmented right now due to differing policy views, though that may not be the only area her talents are in play. There is no doubt that Mrs. Lagarde honed her negotiation skills during her time as Managing Director of the IMF, where she became one of the few to come through the fall-out of the financial crisis with credentials enhanced, though the assumption that all of her efforts will be spent on just the Governing Council itself could be misplaced. Her predecessor Mr. Draghi often spoke of the need for ‘other actors’ to step up to the plate, and Mrs. Lagarde will undoubtedly use her skills in driving this message forward, while at the same time bringing all functions of the ECB onboard.”

Let’s return to NIRP.

At NIRP’s peak, there was about $17 trillion in negative-interest-rate debt trading in the world. That is a market-based pricing reference (Bloomberg, BIS). In the latest serious paper on the subject, by the Bank for International Settlements (BIS), this organization of global central bankers downplays the damaging qualities of NIRP and tries respectfully to defend negative rates, even as it sponsors the notion of resuming normalcy. The paper, CGFS Paper No. 63, “Unconventional monetary policy tools: a cross-country analysis,” was prepared by a working group chaired by Simon M. Potter (Federal Reserve Bank of New York) and Frank Smets (European Central Bank) and published in October 2019. Very observant readers may note that Simon Potter was still at the Federal Reserve Bank of New York at the time of the writing of this report. The paper is available here:

Office-holding central bankers frequently seem to have trouble admitting their errors. Former central bankers are often more direct. Their growing criticisms of NIRP have been clear and forceful and have not fallen entirely on deaf ears. Now, some central banks in Europe are actually shifting their policies to reverse negative rates and commence a return up to zero and then to positive rates and more normalcy.

Meanwhile, in America, President Trump, who incessantly bashes the Federal Reserve and its chair, Jay Powell, recently tweeted again that America should pursue negative rates, because, he believes, that is how we can compete with Europe. Here is the October 29 text of @realDonaldTrump on the subject of NIRP:

Trump repeated his call for NIRP immediately following his recent meeting with Jay Powell and Treasury Secretary Steve Mnuchin. Trump’s inadequacy in monetary economics is confirmed by his quotes. The president is alone on this NIRP quest. His own closest advisers, including Larry Kudlow and Steve Mnuchin, know that negative rates are poisonous. They remain dutifully silent. Fortunately, the Federal Reserve and Jay Powell join most of America’s market agents in ignoring Trump’s Twitter storms. We do, as well. It is clear that our current president knows nothing about monetary policy.

Let’s get to why NIRP has been so damaging over time.

A little history is important. The US did not dive into NIRP in the aftermath of the financial crisis a decade ago. The reasons it didn’t have been subject to debate. There was certainly some discussion of NIRP. Ben Bernanke has admitted that he thought about negative rates during the financial crisis. He has stated that he didn’t pursue them because he was worried that NIRP would risk a meltdown in US money market funds. That was shortly after the failure of the Reserve Fund during the crisis period. The Reserve Fund failed because Lehman failed and the Reserve Fund had large holdings of Lehman paper; hence, it “broke the buck” when the net asset value went under par. That vulnerability triggered emergency actions by the Federal Reserve to restore confidence in money market funds and separately in bank deposits.

At the time of its failure, Lehman was a primary dealer with the Federal Reserve. Market agents viewed primary dealers as a “private club” whose membership protected the members from failure. Market agents had already seen Bear Stearns merged instead of failing. They had already seen Countrywide merged instead of failing. It took Lehman’s failure to undermine the myth that the Fed would save primary dealers regardless of costs.

The bottom line is that the US dodged a bullet and didn’t resort to negative rates (NIRP). The US stopped at zero (ZIRP).

Readers, please note that this is a very simplistic discussion of history. The various central banking moves and policy shifts during the financial crisis require textbook-level analysis to understand. Many excellent references now exist. That worthwhile study lies beyond the limitations of this essay.

To understand how NIRP creates damage, one has to grasp the notion of “forward rates.” Here is the classic definition: “A forward rate is an interest rate applicable to a financial transaction that will take place in the future.” Now combine that concept with the corresponding notion in the currency markets. Here is that definition: Currency forward contracts and futures contracts can be used to hedge the currency risk. For example, a company expecting to receive €20 million in 90 days can enter into a forward contract to deliver the €20 million and receive equivalent US dollars in 90 days at an exchange rate specified today. Source:

Let’s do a simple transaction and then demonstrate it with a graphic. When the yield curve is with positive rates (above zero) and positively sloped, forward rates are computed by traditional methods. Here’s a basic calculation. Assume that the one-year rate is 1%. And assume that the two-year rate is 2%. So a borrower or lender or saver or investor has to decide on one year versus two years. We can compute the forward rate estimate for a one-year term, one year from today. Obviously, that would be 3%. In other words, there is no difference in final outcome between a one-year period for 1% and a second one-year period for 3% versus a two-year period at 2%. After two years the outcome is the same. I’ve purposely ignored technical points such as a compounding factor, semiannual payments of interest, and other conventions.

The business decision for each party is whether to take a one-year term and a second one-year term or to lock up a two-year term. The decision is based on the market agent’s opinion on what the rate for a one-year term will be, one year from the beginning. Note that the business parties can do notional interest-rate swaps as derivative transactions and take either side of the bet. Also note that a “positive carry” exists for the agent who gets paid the two-year rate while paying the one-year rate and taking the risk on the second year. That is how an interest-rate swap works.

Now think of this and combine the forward interest-rate calculation with the forward currency exchange rate. Here the market agent injects a cross-border component into the transaction. The question becomes, what will the exchange rate be one year from now, and what will it be two years from now? There are futures markets pricing those expectations every day.

In an international transaction the payments mechanism requires both the forward interest-rate mechanism and the forward exchange-rate mechanism. These are very large and liquid markets. Global analysts follow them minute by minute every trading day. At Cumberland our investment committee and all portfolio managers receive them daily and in the morning at market openings.

The combination of currency risk and interest-rate risk is complex enough when all interest rates are positive. Again, these transactions are usually found in the notional derivatives among major financial institutions. BIS estimates that the total notional derivative amounts outstanding exceed $500 trillion. The underlying gross market value of those contracts is estimated at about $13 trillion.

Enter NIRP, and it gets a little crazy.

Try this for an example. The one-year term is a negative interest rate of 1%. The two-year is a negative interest rate of 2%. Thus the forward rate for the one-year term one year from now is a negative interest rate of 3%. Naturally, we would be puzzled by such an extreme outcome.

We’ve created a stylized concept chart showing the example above, using yield curves starting at 0.50% in USD and -0.50% in euro. We’ve extended those curves to ten years. Note that the yield in ten years is 2.9% in USD and -2.9% in euros. Thus the yield at the ten-year maturity is less extreme than the forward rate at the one-year or two-year tenor. Remember, this is a concept chart for descriptive purposes; the actual rates will follow in other charts. Here is the concept chart:


You can view a larger version of this chart here:

Suppose these simplistic explanatory examples are the actual positive and negative yields, and further suppose that the positive yield is in US dollars and the negative yield is in euros. Try to guess what the foreign currency forward rate has to be in year two. Please note that we are using hypothetical and symmetrical yield curves for simplicity’s sake. In the real world these curves change constantly and are not symmetrical. They also involve numerous currencies and not just the USD and euro.

It is in that real-world trading (guessing) game that NIRP does its damage. Think of it this way as we continue to refer to the concept chart. At the front end of the series, the USD positive rate of 0.5% and the euro negative rate of -0.5% present a spread of 1%. At the one-year maturity, the positive rate of 1% in dollars and the negative rate of 1% in euros combine to present a 2% spread between dollars and euros. Simultaneously, the positive rate of 2% USD at the two-year term and the negative rate of 2% on the euro create a spread of 4% at the two-year term. Let’s stop and summarize: 1% spread at shortest term, 2% spread at one-year term, and 4% spread at two-year term.

But what happened with forward rates? Because of NIRP, the forward rate for the second-year results in a 6% spread. Why? Because the dollar forward in year two was positive 3% and the euro forward in year two was a negative 3%. Now you have an impossible pricing model. Rates linked between the two currencies would create a yield curve of 1% to 2% into a spread curve of 2% to 4% with 6% in between. How can any business transaction manage its way through that?

Furthermore, the notional pricing of the trillions of dollars and euros in swaps and derivatives is thrown into disarray. As a result, the banks and market agents sponsoring those derivatives must raise their pricing to protect themselves from this added risk induced by NIRP. When they raise their pricing, they add to transactional costs and therefore suppress economic activity at the margin. That is a reason NIRP slows growth and raises risk.

Also remember that the carrying risk is reversed with NIRP. In the USD conceptual example we created, the swap party is paid for the risk by taking the longer side of the derivative. Recall that the two-year USD was getting paid 2% while paying the one-year 1%. The reverse is true in NIRP. Because NIRP is a penalty system, the bias favors the shorter term since the penalty is smaller. Why pay 2% for a two-year risk and select two years versus paying only 1% for a one-year risk? So NIRP reverses the order of the intuitive risk/reward system. Hence the USD agents are buyers of the longer term while the euro agents are sellers of the longer term. This is the place where the derivative markets intersect with the actual markets. Prices of longer-term USD assets are bid up while prices of shorter-term NIRP euro assets are favored.

However, USD bond prices (really all asset prices) fluctuate more than those of euro NIRP-influenced assets. This may help explain the stellar relative performance of the US asset markets relative to their European counterparts. The reason is that the USD assets are mostly of longer and intermediate maturity and therefore more volatile. (This is how the concept of duration works.)

Remember, the US Fed anchors the interest rate (fed funds and IOER) in the very short-term end of the yield curve. Thus the farther away an asset maturity is from the central bank’s anchorage, the more volatile (in both directions) the asset price is. In Europe, the ECB is using a two-rate structure (short-term rate and TLTRO, which is an intermediate-term rate). That dampens volatility, as the ECB policy now targets two different maturity positions on the yield curve. As soon as a central bank targets two points on the yield curve, market agents can quickly use forward rates to fill in the rest of the yield curve.

Note that what I have described above works to gradually flatten yield curves in both euros and USD. In theory the curves eventually become parallel, and only the currency futures derivatives determine their shapes. At this point the power of the monetary authority is really fully neutralized. We may be at that juncture today.

While the numbers used above may seem extreme, the concept applied is not. These types of transactions occur continually. Between major financial institutions, they are usually booked as notional derivative entries by the largest banks that handle these transactions for the business agents.

Take the example of an American hospital purchasing medical equipment from a German company like Siemens. For the American organization, the contract is payable in US dollars. Siemens wants to receive euros. Assume that the time differential between placing the order and completing delivery is two years. Assume that there are progress payments due midway, at the one-year maturity.

How is the transaction handled? Complex notional derivatives capture the forward rates in interest payments made in dollars and euros and also the forward currency exchange risk. Those contracts are computed off the respective yield curves in both countries. They are a derivative with a positive interest rate on one side and a negative rate on the other side.

Readers can quickly see how much cost will be added to the equipment sale because of this unusual circumstance. Both the German and American firms will confront cost increases. And that macroeconomic effect becomes a financing challenge to both parties and exerts a downward pressure on economic activity. The American firm may defer the purchase, and the German firm may experience a manufacturing slowdown. Both suffer from the exaggeration of transaction costs created by NIRP.

In the simple example used above, the one-year forward rate advances from a 2% spread in the first year to a 6% spread in the second year. That scenario causes market agents in both currencies to engage in secondary transactions since they know the spread makes no sense. They commit to other derivative spreads, and that strategy eventually acts to flatten the yield curves in both currencies.

Now look at the shape of the yield curves when negative rates were first introduced in Europe. The negative-rate countries eventually reached a negative inversion. The positively sloped US dollar yield curves faced flattening pressures. Today both curves are flattish. That is what we had to expect when this bizarre NIRP policy was implemented five years ago.

Below we are going to show this phenomenon with a series of charts we used in a private briefing speech to the YPO-Gold organization. This is a group of present and former CEOs who were part of the Young Presidents Organization during earlier stages of their careers.

In the chart below, readers can see an actual, positively sloped dollar yield curve and an actual, negatively sloped euro curve. The forward rates are estimated (2.30% in USD and -1.28% in euros). The rates used in the chart are estimates from actual history.


The subsequent charts were selected to allow readers to see the yield curves for key events. They are for the day after the Brexit vote, the day after Trump’s election, and the day of the Swedish NIRP low of under -1.0%.







Note how the yield curves eventually flattened and became more and more parallel over time. That is precisely what we would expect from the construction of NIRP in one currency and positive rates in another currency (USD). Also note that we are showing five currencies. The US dollar is the positive one in all cases. The other four currencies are the euro, the Swiss franc, the Swedish krona, and the Danish krone. Now think about the complex and costly derivatives that must be constructed to arbitrage among these five currencies.

And think about the fact that the euro is the dominant currency in Europe; but the currencies of non-eurozone countries such as Switzerland, Denmark, and Sweden also have yield curves; and the banking institutions in those countries have associated counterparties, creating a multicurrency and multiparty derivative structure. That structure is what we have today. And note in the chart below how all these yields curves are even more flattened and more nearly parallel today:



All this is difficult enough when interest rates are positive and yield curves are positively sloped in normal structures. NIRP has made the situation much worse.

I haven’t added the effects of NIRP in destroying savings and savers’ incomes. And I haven’t added the mess created by the trade wars, which inject risk and cost into the transactions. Think of what it means to deploy a tariff in the middle of the supply chain for my American hospital/German equipment example, and you can see what a mess this quickly becomes. The consequences are spelled out in a recent article by Jean Pisani-Ferry of the Peterson Institute for International Economics, “The Euro Area Has Run Out of Pure Monetary Policy Options to Avert a Recession,”

Our conclusion: NIRP is poisonous. Always has been and always will be.

Markets are now adjusting to the prospect that NIRP will recede. The total NIRP debt aggregate has declined from $17 trillion to under $12 trillion. Markets are also discounting that scenario, as we see in changes in the yield curves of all currencies. Should the disastrous Navarro-Trump trade war policy (a protectionist policy that has demonstrably harmed what it proposes to protect) also be reversed, we can develop a positive outlook for global growth. Get rid of NIRP and of the trade war, and markets and growth rates will soar.

For now, we remain partially invested in our US stock market ETF accounts. We have taken profits in our quantitative strategies. Our bond barbells have helped us preserve “dry powder” for redeployment at higher interest rates.

Meanwhile, American politics has undertaken an assessment of Trumpian political arrogance and will determine whether a vision of unbridled presidential power prevails. The re-election of Trump is now too close to call. However, the opposition to Trump is still not clearly determined. Some of the Democratic contenders are worrisome. The coming campaign promises to be a multi-billion-dollar fiasco with endless nasty attacks and misinformation on all sides. It will be made exponentially worse by the impeachment battle. This Politico piece runs down the risks: “Why the Impeachment Fight Is Even Scarier Than You Think,”

And we worry about the socialism advanced by leading candidates. Most recently, we witnessed the introduction of new lower estate tax thresholds in the House by Congressman Jimmy Gomez (D-Ca). (See That bill matches democratic socialist Bernie Sanders’ Senate version and has made the Sanders-Gomez estate tax thresholds into a live bill. It won’t pass this term, but it is a possible harbinger of things to come.

And there may be a repricing of all things in financial markets. See this piece, in which Christopher Whalen of Institutional Risk Analytics reckons with Warren’s plans: “Elizabeth Warren Wants to Crash the Global Financial Markets, ”

Okay. Lots of things to think about as we approach the holiday season. The iconic and prolific author Charles Dickens opened his famous novel A Tale of Two Cities this way: “It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity.”

There was no NIRP when Dickens’ life spanned the middle of the 19th century. But there were profound conflicts driven by intensely divisive politics. Some things never change.

To all clients and friends of Cumberland and to all of our colleagues in organizations whose efforts try to make the world a better place (sometimes in spite of itself), we wish you the best and safest holiday season.

David R. Kotok
Chairman and Chief Investment Officer
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