Month: October 2016

When negative rates mean tightening – Deutsche Bank and monetary policy

(The views in this post are a result of armchair theorizing. I have not looked into Deutsche Bank’s (DB) financial reports in detail because I believe financial accounts are unreliable for this type of financial institution anyway. For this reason alone the stock is generally “uninvestable” and, as a consequence, I do not have any positions on. My interest in it is purely due to monetary, i.e. macro aspects).

Deutsche Bank has been in the headlines lately, its stock price crashing and the main political actors trying to calm markets. The main culprit, according to the consensus, is a higher-than-expected fine (14 billion US dollar) for malfeasance during the mortgage boom ten years ago. While it goes without saying that a higher than expected liability should have negative effects on the stock price, I believe it is not the main problem ailing DB.

That’s because DB’s share price had already lost 2/3rd of its value over the previous 12 months, i.e. long before the fine was made public. It seems DB’s problems have only remotely to do with the fine. Clearly, something else is at work here.

That something, I believe, can be summarized with the following chart (via Macronomy),


It shows the EURUSD cross currency swap (CCY) basis over the past ten years. As one can see, the basis has been negative since the beginning of the financial crisis. A negative basis, means that (secured) US dollar funding more is getting more expensive for a bank that needs dollar funding (and has to post EUR collateral), as it receives less than the market rate (Libor) on its EUR collateral – therefore the negative sign (here for a good introduction).

Cross Currency Swaps – the Basis of the Global Financial System

CCY Swaps are at the heart of the Eurodollar System. Whenever someone outside the US takes out an US dollar loan at his local bank, chances are high that the bank’s dollars have been sourced via swapping its local currency deposits into dollars on the Eurodollar market. Unless the bank is based in a Petrodollar country (Russia, Saudi Arabia, Norway etc.), it is unlikely to have sufficient US dollar deposits to engage in simple US dollar fractional reserve lending. Since unsecured lending via bonds is way more expensive, CCY are is the preferred and easiest route for banks to go. It is through this market that US monetary policy is (unintentionally) disseminated across the globe.

Short on deposits, Investment Banks are heavily dependent on the wholesale market for funding. As a result of their global ambitions and due to the fact that 70 percent of global financial transactions occur in US dollars, this means largely US dollar wholesale funding.

DB is the biggest continental investment bank. And this is precisely its biggest problem. They do not disclose how much of their balance sheet is US dollar denominated, but I suspect it is a lot (just flying over the annual report, I note that it is very, very light on specific information). For that reason, if wholesale funding in US dollars is rising, it hurts their business model disproportionately, which is even worse than a one-time fine. (The second is Credit Suisse which according to Jeff Gundlach (here) might be even worse and shows a similar stock price trajectory despite the absence of a similar fine).

So what is causing the US dollar cost of funding to rise?

Some people are blaming a “US dollar shortage”. That’s what happened in 2009 and 2011/12 when asset markets in Europe (and globally) were crashing because market participants had to liquidate assets to generate US dollar liquidity. In 2012, during the height of the Euro crisis, investors were fleeing Europe, or at least parts of it. Then came “whatever it takes” – and markets calmed until mid-2014, with the basis widening ever since.

If there is an US dollar shortage I do not know what is causing it. Contrary to 08/09 and 11/12, asset markets have been booming in this period – at least in Europe and the US. This year even Emerging markets and commodities have re-joined the rally. Yes, there are issues in China, but the CNY has barely moved (sorry to disappoint, but 2 percent is not a devaluation). In short, this doesn’t feel like a US dollar shortage (yet) – but the CCY basis remains unimpressed.

What else could be the reason?

I believe a big factor this time is negative interest rates, first imposed in June 2014 (red line in the Chart) and subsequently lowered to -40bp as of today. As one can see, the CCY market has deteriorated steadily since then, reversing the normalization phase of the previous two years. That’s the empirical evidence, but correlation doesn’t prove causation and the pattern observed could just be coincidence – we need a good theory of cause and effect.

When negative rates mean tightening

I have written about how negative interest rates will kill European banks’ top line going forward using the example of Italian (here) and Spanish banks (here). These are the direct consequences of negative interest rates, and its effect will soon be seen in the aggregate NIM of the European banking sector.

What is (or will be) seen, however, is usually not what matters with market interventions. It is the unseen – or unintended – consequences of actions that have far more impact, as Bastiat showed 150 years ago (here). Thinking about the potential unintended consequences of negative rates and trying to figure out why the basis has been negative despite the absence of market volatility, I came to the conclusion that negative interest rates play a big part in the negative swap spread thereby increasing the funding cost for banks that rely on USD wholesale funding. In other words, from the view of DB, Mr. Draghi’s unconventional monetary policy looks like tightening. No wonder, DB has been the most vocal critic of ECB’s monetary policy. After all, DB couldn’t care less about German savers and retirees!

In order to understand how negative rates in Euroland translate into a negative EURUSD basis, it is instructive to go through an example.

A European bank (A) wants to increase its USD business. This could be loans to energy companies and traders, emerging markets and general capital markets activities (such as buying MBS for resale). The bank only has EUR funding (deposits, bonds etc.) and needs to generate US dollars. Sure, it has enough Euros, but it needs to come up with USD. The cheapest way to get your hands on dollars is to enter a CCY Swap.

In a CCY Swap A will borrow US dollars from another bank (B) and pay something like $ Libor, just as it would with unsecured interbank lending. However this would expose B to unwanted (bank) counterparty risk, severely reducing the appetite of B to fund the (ambitious) expansion plans of A. To mitigate this inconvenience, A agrees to lend B Euros in turn thereby reducing the net Exposure between the two counterparties to 0. The principal amounts will be swapped back (or repaid) at maturity.

But we are not finished!

We still have not determined how much B has to pay to A for the EUR loan that forms the second leg of the swap. If B is willing to pay Euribor – minus some fee for the transaction, after all B wants to make a profit from lending its dollars – the market is said to function normally, i.e. the basis is close to 0. As we can see, the rate B can/wants pay A determines, whether the market is said to function normally or not.

And what determines B’s propensity to pay?

Answer: the things it can to with these Euros, i.e. the opportunity set.

Now, before the crisis in 07/08 this must have been fun. Huge “opportunities” presented themselves to banks with spare Euros. Remember, all those banks in the PIIGS taking advantage of historically low rates, handing out far more loans than they had deposits and thus paying up in the interbank markets (see my post here)? Well things have changed since then: bank lending is not considered riskless anymore, and the PIIGS are struggling to decrease, rather than increase their debt levels. Lending out all those Euros is neither feasible, nor attractive anymore.

Without explicit business opportunities, B will view the EUR amount as “mere” risk mitigator, i.e. pure collateral. With this emphasis is on safety, B will be willing enter transactions with zero credit risk and pay a rate close to what these assets yield. In the Eurozone this basically means either ECB reserves or German government bonds. Since those rates have been negative for more than two years, it means that not only is B unwilling to pay much, but A has to pay B for the Euros it has lent (to B). Effectively A ends up paying more than $ Libor.

That’s called a negative basis!

And it’s definitely caused by negative interest rates!


Mr. Draghi is partly right when he claims, as he did recently in the Bundestag, that Eurozone banks’ problems are not the ECB’s fault. This is true for the legacy problems still ailing bank balance sheets across the Eurozone. But it is definitely not true on a forward-looking basis, due to the havoc caused by ECB’s mad interest policies. By introducing negative interest rate, the ECB has unintentionally tightened monetary policy for those banks that rely on USD funding for a large part of their business model. This is certainly the case for DB, the systemically most important bank in Europe.

There is no free lunch and central bankers are not omnipotent. Buying stability for government finances and asset markets must come at a price. In this case the price paid is political turmoil and heightened instability in the banking system. This is a very, very bad trade.

They really do not know what they are doing.