Negative Interest Rates And Global Monetary Policy Divergence

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Summary

The Federal Reserve will be raising rates as other central banks ease further and the U.S. economy maintains or improves.

Europe could recapitalize its banking system allowing further negative rates in the Eurozone.

I expect the Bank of Japan and possibly ECB to push rates deeper into negative territory or broaden the number of deposits it affects.

A steeper yield curve and sufficient banking system capitalization increases the effectiveness of negative rates and lessens the penalty on banks.

An effect of negative rates is currency depreciation providing a boost to corporate export competitiveness.

Negative interest rates have gained a great deal of attention, but many don't understand exactly the effect of a negative interest rate policy. It is a myth that negative rates apply to credit cards, auto loans and mortgages. No, banks do not pay you to borrow. It is designed at the central bank level where commercial banks hold reserve accounts at the central bank and instead of receiving interest on reserves, they are paying interest simply to hold deposits at the central bank. The idea is it penalizes banks for not lending and increases the opportunity cost of not making a loan.

If a banking system is undercapitalized, negative rates could worsen the situation and be ineffective. Higher capital levels are associated with higher rates of lending. Negative rates with an already unhealthy banking system makes the banking system even more weak. Given a well capitalized banking system, negative interest rates could be effective in promoting lending by encouraging banks to hold less excess reserves.

The Federal Reserve plans on increasing the federal funds rate if the economy "stays on the current course", according the chair Janet Yellen in the last post FOMC meeting press conference. This is an opposite policy from the Bank of Japan or ECB who have little concerns about overly high inflation and are likely to ease further through various measures such as deeper or broader negative rates, expanded or extended QE and central bank stock purchases or currency intervention.

Negative rates can be viewed as a form of currency intervention. Although the yen has largely appreciated since the BoJ introduced negative rates, this can be attributed to the Fed being on hold. These central banks are moving in opposite directions with further negative rate potential in Japan and Europe with the Fed raising rates in the near term and over 2017. This will lead to yen and euro depreciation versus the dollar as investors move to higher yielding currencies.

The right monetary policy prescription for the Eurozone is a state backed banking system recapitalization, extended QE and increased use of a negative interest rate policy. Kuroda from the Bank of Japan recently called on Eurozone governments to recapitalize banks. There are recent rumors that the ECB will taper QE which is scheduled to end in March 2017. I think they should and will extend the program. Tapering QE here would be a major policy mistake from the ECB. Not too long ago, the theme in the euro (NYSEARCA:EUO) (NYSEARCA:FXE) and currency markets was the ECB was out of options to depreciate their currency or ignite inflation. Tapering QE here shows a lack of commitment to reaching the ECB's inflation target and the likely action is extending the program beyond March 2017. Longer QE is bearish for the euro currency.

As far as Japan goes, I think the new yield curve targeting monetary policy from the Bank of Japan sets up the potential for a deeper or broader negative interest rate policy. A steeper yield curve is positive for bank lending margins. This is supportive of the banking system and neutralizes the harmful effects on negative rates on banks. In essence, the Bank of Japan has set up a scenario for more negative rates through steepening the yield curve. They also promised to overshoot their inflation target before ending QE. I think this is being overlooked by the markets. An engineered inflation overshoot is bearish for the currency.

It is vitally important for the ECB and Bank of Japan to depreciate the euro and yen, respectively. The United States can withstand a stronger currency, while the Eurozone and Japan cannot. Currency depreciation increases net exports providing a boost to GDP growth and also increases corporate competitiveness globally. Currency appreciation or depreciation can also act as a tailwind or headwind to stock markets (NYSEARCA:VGK) (NYSEARCA:HEDJ). The Japanese stock market (NYSEARCA:DXJ) is inversely correlated to the yen (NYSEARCA:FXY).

In short, the monetary policy divergence theme is still intact. Negative rates allow a new scope to ease policy further and depreciate a currency. As the Fed and ECB/BoJ move in opposite directions, it is reasonable to expect the USD (NYSEARCA:USDU) to appreciate.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.