Gavin Davies reflects in the FT today that the Swiss and Danish central banks put in question the zero lower bound (ZLB), and asks us to imagine what the German yield curve would look like if the ECB followed the example of the Swiss National Bank (SNB). Basically, he arrives at something looking a little like the Swiss sovereign curve today:


For those not au fait with a bond yield curve, it is a snapshot of the yield (think interest rate payable on your capital) for different fixed rate terms. So, on the chart you will see that you could lock in an annual 'rate of interest' of 0.46% per annum for the next fifty years if you wanted to buy a 50 year bond, or lock in an annual rate of interest of minus (yes minus) 0.58% per annum if you bought a five year bond.

Everyone in bondland is quite excited about this move to negative yields in a variety of large bond markets (not least a good portion of the German curve). And Davies is right that this challenges all sorts of thinking. One thought is that the banks 'empty' into cash as depositors choose a higher-yielding instrument. But, as Davies writes:

... cash is very inconvenient to hold and use for large transactions. It can be stolen or lost, so most honest citizens would be willing to hold bank deposits even if they are charged a negative yield for doing so. The key question is how valuable these benefits of security and convenience really are: the more valuable they are judged to be, the further negative that the central banks can drive interest rates on deposits without causing an implosion in the banking system.

I would like to venture that, without setting more radical moves to tax banknotes in train, the first Vault Cash Bond or ETF will be issued before too long in this scenario. Such instruments would pretty easily circumvent attempts to breach the ZLB for very large deposits, and could have the effect of causing bank runs. How would this work? Let's take the Swiss curve as an example.

At the moment, if you want to buy a five year bond you have to lock-in a rate of -0.58% per annum. If you keep your money in the bank you get charged more than this (if the bank passes all its negative interest rate costs through).

Let's say now that I can offer a sovereign-backed bond yielding -0.2%. Same cash flows, close to comparable credit quality, potentially enhanced liquidity (if take-up sufficient). Sounds ok so far. Its underlying would be CHF1,000 notes sitting in a bank vault. A CHF1 billion bond issue would spit out CHF10 million of fees over the course of five years which I am guessing would be more than enough for vault hiring, prospectus-writing, syndicating, and lawyering. Similarly, daily tradable banknote-backed ETFs yielding a tiny bit below zero solve for zero duration cash account needs.

And in one quick blog the ZLB was reinstated.