Indexology^® Blog

The announcement by the European Central Bank that it would charge negative interest rates to banks for their deposits at the central bank – effectively a fee for having the central bank hold the money – raises arguments for eliminating paper currency and going digital.  The pros and cons were summarized in the Financial Times and in some blogs.

Digital money need not mean bitcoins – these suggestions are electronic currency maintained by the central bank.  One would trade the greenbacks in your pocket for the credit and debit cards you already have or an app on your phone. For many people there would be little difference.

There would be one advantage for the Fed: if the economy was weak and they wanted you to spend your money, they could encourage banks to charge negative interest (a fee) for keeping money in the bank.  You could pay the interest fee, spend your money or invest it.  You couldn’t take the cash and keep it in your  bottom bureau draw.  While this might be efficient monetary policy, most of us wouldn’t like it.  Lest this sound completely impossible, it was tried with little result in Denmark recently.  It’s not much different than a checking account where you pay service fees for writing checks.

Leaving aside monetary policy, eliminating cash would have other effects.  No one knows how much tax evasion and other illegal activity depends on using cash, but most believe the number is substantial.  About three-quarters of the total value of US currency is in $100 bills. Stated differently, there are about 30 one hundred dollar bills in existence for each person in the US – that’s $3000 in cash. Most people don’t carry that much lunch money. One offsetting factor is a lot of that circulates outside the US.  Eliminating paper currency would curtail some illegal activity by making anonymous or secret transactions more difficult.

Lest this look like a bonanza for the government, they would pay as well.  Currently the government benefits from the seigniorage from money creation.  It doesn’t cost $100 to print a hundred dollar bill, so the government “earns” the difference between the printing cost and the face value of the currency.

Despite some apparent arguments for eliminating cash, it doesn’t seem very likely in the near future, if for no other reason that it would be unpopular and difficult to accomplish.

On May 27^th, 2014 an article appeared in the Wall Street Journal titled “New Costs From Health Law Snarl Union Contract Talks”. This article provides an interesting insight into the challenges both employers and Unions face under the Affordable Healthcare Act as they try to determine the future cost of health plans that have been in place for decades in many cases. Putting a specific financial value on the cost of a health plan for a period of 3 to 5 years, particularly a known plan covering a known group, should be a relatively routine task. However, under our current insurance/ASO structures, there is no way to lock in such a cost over a multi-year period. Either the employer is at risk if actual costs exceed the projections, or the union must accept a very high risk charge to cover the worst case cost of the health plan. Regardless of how the issue is resolved, the situation is a lose-lose environment for both parties.

This is a situation for which the S&P Healthcare Claims Indices can be utilized. With the introduction of the S&P Healthcare Claims Indices both employers and labor now have a common measure of the average market rate of healthcare cost changes (trend) for any time period. By utilizing the indices, the two parties can now take advantage of several options to structure solutions to resolve the problem. Consider a couple of relatively simple examples:

• The employer and union could agree that the contract will use the index as a neutral measure of market cost changes. By comparing the plan’s financial trend to the market’s trend (in essence “marking to market”) both the employer and the union have a shared goal of improving the plan’s financial results. If the plan’s actual trend was lower than the S&P trend for the same period (meaning that the plan’s financial performance was better than the market average measured by the index) then the plan would have a surplus which could be used to reduce future contributions from the union employees. Likewise, if the plan’s actual trend was higher than the index, then the employee contributions might be increased to cover the shortfall. Under this approach, both parties have an incentive to manage the cost of the health plans as carefully as possible – an incentive that typically does not exist currently.
• An employer could use the S&P Healthcare Claims Indices as the basis to negotiate a financial contract with a third party, such as an insurance carrier, reinsurer or bank, that limits the employer’s liability for healthcare costs in excess of a set trend over the period of union contract. In effect, the employer has entered into a futures contract for healthcare costs. The contract would function as a hedge, in much the same manner as a futures contract is used to hedge commodity costs, or investment performance. The result is that both the employer and the union could determine the cost of health care benefits under the union contract with a high level of confidence. Both the union and the employer would understand the value of the healthcare program – and they could then decide whether to make changes to the plan provisions in order to change that cost.

Futures contracts are a well understood mechanism and have demonstrated their value across any number of markets. Is their utilization as to hedge against future health care costs just the next step in this financial structure’s evolution? The index linked approach would also work much the same way as reinsurance or catastrophic insurance in other insurance markets, with the indices being used as the final settlement value to the cost guarantee.

The European Central Bank (ECB) announced negative interest rates. The rates apply only to certain funds that banks keep on deposit at the central bank. Negative interest rates do not apply to individuals’ bank accounts. If a bank has one million euros on deposit with the central bank, a year later it will have a thousand euros less – it will have paid interest to leave the money in the central bank.  And that is exactly why the ECB is charging for holding the money – it wants banks to loan the money to businesses to encourage investment and economic recovery.

This unusual move – tried once or twice before in other countries with little result – is because the European economy is weak and prices are on the edge of falling into deflation.  The ECB describes this as the logical extension of normal monetary policy: when inflation is too high, the central bank raises interest rates in an effort to deter borrowing by making it more expensive. When inflation is too low, prices are close to falling and the economy is weak, the central bank cuts interest rates.  The latest reductions announced today (June 5^th) pushed interest rates down with the rate for refinancing operations, similar to the Fed Funds rate in the US, at 15 bps. To keep a 25 bp spread above the rate paid on bank deposits at the ECB; the deposit rate was reduced to -10bps.

This isn’t likely to create a surge of bank lending overnight. First, the drop into negative numbers seems as much a symbolic statement as a serious plan to charge banks.  Second, there are not too many immediate options for banks. They could withdraw deposits from the central bank and hold the funds as currency.   The amounts are sufficiently large that where it is stored, and how it is protected, are real issues. A bank could try to deposit the funds in another bank, but this just means a lot of liquidity looking for a home.  Hopefully the news of negative interest will encourage business to spend or invest once they realize that money is (almost) free, for the moment.

Deflation is both a sign of economic weakness and a real danger.  In a weak, no growth economy there is no pressure on prices, little demand for most goods or services and flat to falling wages as unemployment rises.  Falling prices signal spreading economic malaise.  Deflation can be a greater danger – when prices fall, just about everything except for cash is worth less; cash is worth more because each dollar buys more.  In effect, dollars are more expensive.  A borrower needing money to repay a loan must work longer and harder to repay the loan because his labor is worth less. This debt-deflation spiral can send an economy into a deep recession or worse.  This is why the ECB and others fear deflation.

Climate scientists are predicting record breaking global temperatures from an El Niño expected this year that could boost commodity prices from further disruptions in the supply chain.  This year has already been chock-full of supply shocks across many commodities such as nickel, natural gas, coffee and hogs, creating critically low inventories that will be extremely difficult to replenish – especially in volatile weather conditions.   

Already climate change has impacted the agriculture sector, so an El Niño may have an even greater impact amid the global warming. Does this mean there may be an opportunity for outsized returns from agriculture or other sectors?

The Oceanic Niño Index has indicated eight historical El Niño periods in the time frame since 1983, when sector data is available for the S&P GSCI. Surprisingly, it’s not the agriculture sector that benefits, at least right away. Notice only 4 of 8 periods resulted in positive returns for the S&P GSCI Agriculture with a slightly negative average return of 88 basis points.  However, livestock fared better with premiums of 7.4%, and the metals showed positive performance in most of the periods with average returns of 25.3%  and 8.9% from industrial metals and precious metals, respectively. The super high return in 1986-88 is interesting since the commodity stock cycle was at a similar turning point as today.

Despite the average positive returns in all sectors except agriculture during El Niño, this does not mean there are no opportunities to profit in agriculture from the crazy weather.  The spikes in the sector happen with a lag, so it could take up to a year or more to feel the impact though usually at least one spike happens very soon after.  On average the first spike month has returned 16.6% with several possible high spikes following. Please see the table and chart below.

Last month, as in many this year, the majority of developed markets eked out respectable gains. The S&P 500® closed May at a new high, as did the S&P Global 1200 index of worldwide large cap equities. The S&P Europe 350 nudged up to levels not seen since 2007. All would appear to be going well.

Nonetheless, such calm markets prove fertile ground for speculation. Particularly of note is a swathe of articles and commentary pointing out that implied volatility (measured, for example, by the VIX) is low, and options prices are very, very low. Have the actions of central bankers made the equity markets become complacent? Or is the VIX somehow “broken?”

The first question is beyond us. We just don’t know if the average investor is currently guilty of irrational exuberance, and we would be suspicious of anyone who claimed to know just how exuberant we should be. Forecasting is no easier now than eighty years ago.

Most of the investors I’ve spoken to recently are in fact rather worried about what’s next, but there’s a wide spread of opinions as to what one’s primary worry should be. That speaks – perhaps – to a decrease in correlations as much as to a decrease in volatility. And there’s certainly evidence to support this, notably from an ex-U.S. perspective:

Source: S&P Dow Jones Indices Correlation & Dispersion Index Dashboard, June 2^nd 2014

One of the features of volatility (measured at the level of whole markets) is that it’s very dependent on correlation, although the relationship is subtle. If stocks move independently, their aggregate impact on the market is diminished. If stocks move together, the market whips around with their combined movement.

As we’ve noted before, it is entirely possible that correlations will spike up in response to a macroeconomic crisis event. In the meantime, however, the prevalently low correlations are providing diversified investors with an unusually smooth ride.