News that the 10-year Japanese bond plunged to a negative yield has put the focus on what some are calling the most visible effect of the failure of the latest and most controversial central bank policy, negative benchmark interest rates.
Record negative yields in government bonds across the globe are showing that investors have so little faith in the ability of central banks to fight deflation or recession, that they are willing lose money for the safety of these bonds. Negative interest rates have failed to stimulate the economy, while pummeling banks and lenders. This is raising questions about the ability of central banks to halt economic slowdown after eight years of trying. Some are questioning whether they even know what they’re doing.
Safety Trumps Returns
A logical question would be, “Why are people buying these bonds when it means they are paying for the privilege of loaning the government money?” If you hold the bond until maturity, you get back less than you paid for it!
But how does the yield on a bond drop to zero and beyond? The answer is “fear.” If you believe that your money is going to get devalued by your central bank’s policies, you look for a way to preserve your buying power for the future. You will accept a negative yield (paying to loan the government money) if you believe the value of your money will drop more than the negative yield you receive on the bond. Investors consider this negative yield as an “insurance premium” they pay for the protection of their money. One of the safest places to put your money is in the bonds of one of the leading nations, even if you have to give up a positive return.
So, How Do Bonds Get A Negative Yield?
In times of crisis or economic uncertainty, the demand for “safe haven” bonds grows. As the demand for these bonds increases, people are willing to pay more to acquire them. If demand is higher than supply, the people that own those bonds can now charge a higher price than what they paid for them.
The more you pay for a bond, the smaller the effective yield will be, because you are paying more than the original principal that you will get back at maturity. This is why you see the yield rates on bonds constantly change with market conditions. Remember: When bond prices go up, the yield goes down.
So, how does a bond have a negative yield? This is a very recent phenomenon. 18 months ago, no government bonds at all had a negative yield. But as more and more people become afraid of the stock market or currency devaluation, they look for the safety of government bonds. Since the Eurozone is the most prominent area where deflationary concerns exist, and the European Central Bank is buying government bonds (which shrinks the supply,) this is where we saw the first negative bond yields. Swiss and German bonds were the first to go “sub-zero,” because the demand for these ultra-safe assets (compared to Italy or Spain) outstripped supply.
$7 TRILLION in Negative Yield Sovereign Bonds
There’s now $7 trillion of government debt with yields below zero. This is not far off being 1/3 of the world’s entire sovereign bond market.
Five weeks ago, the amount of government bonds with negative yields was half that. 18 months ago, NO government bonds had a zero yield.
More than 40% of the €7 trillion government bond market in Europe has yields below zero.
The average yield on the Bank of America Merrill Lynch World Sovereign Bond Index stands at 1.29 percent, the lowest since records began in 2005.
Scary, ain’t it?
Does It Even Work?
“In theory, there is no difference between theory and practice. In practice, there is.”
Negative yields are a result of central bank policy. Central banks want to push people into spending. Ordinary people, pension funds, corporations, banks. They want all of them to stop saving and spend (or lend.) In their minds forcing people into the stock market or junk bonds will stimulate the economy. To make government bonds less attractive as an investment, the central banks will buy billions of dollars worth of bonds every month, using digitally created money.This decreases the supply of bonds, forcing prices up and yields down.
Another tool is reducing benchmark interest rates that are used to determine the yields of many other assets. Most central banks went into ZIRP (Zero Interest Rate Policy) mode shortly after the 2008 financial crisis began. This was supposed to encourage lending to subprime borrowers and get the economy (and inflation) back on track. Hey, it worked so well in the housing market, right?
Except, the economy didn’t pick up. Neither did inflation. In fact, the Eurozone saw recession AND deflation. In June, 2014, Mario Draghi and the European Central Bank were the first to step into the financial Twilight Zone and charge banks for storing their excess funds with the ECB. This move was to coerce the banks to lend the money out to people that they normally wouldn’t, and stimulate the economy.
This is something that traditional economics said could (or should) never happen.
Denmark and Switzerland, both trying to keep their currency from over-appreciating against a lackluster euro, soon followed suit. In their cases, it was partly to chase foreign “hot money” out of their markets to slow down the growing strength of the Swiss franc and Danish krone. This forced the Swedes to go negative with their interest rates as well, for the same reasons.
But, these desperate measures don’t seem to have worked. Instead of forcing money to be lent into the economy, negative interest rates chased this money into people’s mattresses, or completely out of the country to find positive yields.The only markets that have benefited from negative interest rates seems to be the bond markets (and gold.)
The Bank of Japan was the latest central bank to implement negative interest rates, in part to devalue the yen and help Japanese exporters (and cause inflation.) This plan fell apart the same day it was implemented, as the yen saw generous safe haven demand due to conditions in China, and got stronger, instead of weaker.
A growing number of analysts see the foray of central banks into the formerly taboo realm of negative interest rates as proof that all the quantitative easing and rate cuts have failed.
Does Yellen Have A Choice?
The Federal Reserve in the United States is the only major central bank to have raised benchmark interest rates since the financial crisis. The head of the Fed, Janet Yellen, said that the 0.25% rate hike was to send a signal that the American economy had recovered enough that the extraordinary stimulus measures in place since 2009 could start to be rolled back.
She apparently underestimated the impact this move would have on a strong dollar, which was already hurting exports and commodities. The dollar shot higher, and only came down when the stock markets began a serious correction. Traders blame the Fed’s rate hike for the worst January Wall St. has seen in decades.
The pain the markets are feeling from the stronger dollar and higher benchmark interest rates have led almost everyone to ignore the Fed’s stated plan to hike rates four more times in 2016. In fact, Treasuries are seeing even more demand, as investors rush to lock in the best interest rate they can?
Why? Because everyone outside the Fed believe that not only will Yellen be forced to roll back December’s 0.25% increase, but she will have to join her central bank comrades into negative interest rates, which will spawn negative yields. It will also make America a latecomer to what is shaping up as a global currency war to stimulate national exports by devaluing their currencies.
The opinions and forecasts herein are provided solely for informational purposes, and should not be used or construed as an offer, solicitation, or recommendation to buy or sell any product