Sorry Mario, Negative Interest Rates Favour Stashing Cash in the Mattress Rather than Spending!

In theory, nominal interest rates are not suppose to be negative. This is because simply stashing cash in the mattress earning nothing dominates the negative rate of return associated with a bank deposit carrying a negative interest rate. Arbitrage, the second strongest force known to man next to gravity, should operate to keep nominal interest rates above zero. While this logic is compelling, strange things can happen…

The European Central bank has successfully driven short-term European interest rates into negative territory and, moreover, have been able to keep them there despite what must be very strong arbitrage forces. Their reason is to encourage spending rather than saving.

Big institutions don’t have big mattresses apparently. They need to park their electronic balances with electronic custody platforms administered by the ECB paying negative electronic interest. The man in the street, on the other hand, does not have this restriction. Can “the little man” benefit from the arbitrage opportunity?

The currency futures market might well deliver this opportunity. Euro USD futures are pricing in a 40 basis point per annum interest rate differential between US and Europe. US T-bills are paying 4 basis points per annum which means the implied European interest rate is -36 basis points. Therefore, anyone with US dollar cash can buy euro, stash it in the matress, sell the future forward and deliver the euro in three months time for a 36 basis points per annum gain. Furthermore, those investors who can borrow USD at less than 36bp can simply do this over and over again – a sort of money machine.

While few of us can borrow at the Tbill rate, in practical terms anyone with USD balances are better off holding Euro and selling futures against it since that generates a synthetic USD ‘riskless’ deposit earning 0.36% versus the alternative of Tbills at 0.04%. While not earth shattering, this is something for nothing.

Ironically, the arbitrage opportunity that the ECB has created encourages investors to stash away cash rather than spend it. This runs directly counter to the aim of negative interest rates which are supposed to encourage spending!