It’s commonly assumed that interest rates of any sort of debt has to be positive, because it just doesn’t make sense otherwise: why would you pay someone to hold on to your money for you when you can do the same by putting it in the bank and earn interest? If you don’t trust the bank, you could still withdraw it in cash and put it under the mattress for safekeeping so logically they shouldn’t exist. But if you go to your preferred financial press and do a quick search for current rates on Swiss 2 year bonds (on Bloomberg) for example, at the time of writing the yields on these things are negative. But we just said that they don’t make sense…?
Possible causes of this peculiarity is likely due to a specific set of circumstances : the Swiss Franc is a currency that people around the world turn to in times of trouble due to its perceived stability. Because of the economic downturn in Europe and America it’s no surprise that everybody wants a bit of Swiss-made safety and the fastest way to get a lot of money converted into Swiss Francs (CHF) is to buy government bonds, an asset readily redeemable for cash. This has the effect of bidding the prices on the bonds up and reducing the return for holding the bond causing nominal yields to reach zero.
In a ‘normal’ economy, you would expect the rational people to start selling off Bonds because there’s no advantage to holding them compared to cash. If you’re unfamiliar with finance, the market value of a bond is higher when the yield is lower so it usually makes sense to sell out when the rate is zero. But because international demand for Swiss currency far exceeds supply (you need Swiss Francs first before you can buy those bonds), this puts a strain on the Swiss financial system as you’ve got deflationary effect on the economy, manifesting itself as a strengthened and possibly overvalued currency, not something the policy makers want in a recession.
Thus to fight the external demand for Swiss Francs to avoid crippling the Swiss economy, Swiss central bankers have resorted to unorthodox methods, namely expanding money supply further, i.e. printing more money, by flooding the market with more bonds and driving the yields on the bonds negative, in the hopes of devaluing CHF. In hindsight this had the Swiss National Bank (SNB)’s intended effect as people finally sought other places to park their money, stabilizing what was then (August ’11) a rapidly rising Swiss Franc.
While helpful with exchange rate issues, a pitfall of pushing interest rates negative is that banks, where money in the financial system tends to end up, don’t want to lend it out because they don’t make money from doing so thanks to low interest rates. Coupled with a recession where business is risky, means banks are likely to hoard their cash making it difficult for industries and start-ups to get funding, further exacerbating the economic downturn.
As with all central banks, the Swiss National Bank has a delicate balancing act to do: giving the economy the right amount of encouragement to prevent disaster caused by foreign markets, but not enough so that it sends local business conditions into chaos. Negative interest rates, while rare, definitely do exist under certain circumstances and is a viable monetary policy.
When a government bond becomes a Giffen good on the Financial Times , http://ftalphaville.ft.com/blog/2011/08/11/650656/when-a-government-bond-becomes-a-giffen-good
‘Treasury Potatoes’ at The economist, http://www.economist.com/comment/1136110#comment-1136110