Getting to grips with the world of negative rates
NEGATIVE interest rates (NIRS) flies in the face of conventional wisdom (CW) about how financial markets should behave.
CW has it that “real” rates – i.e. interest rates adjusted for inflation, can often be negative. But, prior to 2009, it was thought not possible for “nominal” deposit rates to dip below zero. The Swedish Riksbank (central bank) was the first to adopt a negative deposit rate in July 2009. Previously, it was also used as a currency lever: Denmark used it to deter capital inflows to maintain the Danish krone’s peg to the euro; and the Swiss used it to stem the franc from appreciating too sharply. But, it has since gained currency as yet another tool of monetary policy to forestall deflation, promote lending and nurture economic growth. Indeed, it’s now a fact of life.
NIRS first started in 1890 by Silvio Gesell, a colourful German businessman.
His idea was later championed as a possible solution to the Great Depression.
Lord Keynes called Gesell “a strange, unduly neglected prophet.” The idea then languished, until it was picked up by the Riksbank, which has a reputation for innovation (it pioneered inflation-targeting, for example); in mid-2009, it imposed the first ever negative rate on deposits held with it by commercial banks. This was intended as a brief experiment. When Sweden again flirted with deflation in the wake of the eurozone crisis, the Riksbank in February 2015 pushed its main borrowing rate below zero. It has stayed there ever since.
The overall effect according to the Riksbank was positive: “Mildly negative interest rates have successfully contributed to more expansionary monetary policy.” However, some researchers, including Harvard’s Lawrence Summers, contend that such a policy offers “diminishing returns.” Others argued that the net impact on the economy is likely to be neutral. While bank profitability remains solid, the limp krona failed to stimulate exports and the country’s savings ratio actually rose despite negative rates. Still, negative rates drove many Swedish companies to keep more money overseas.
Meanwhile, low rates have pumped-up the Swedish real estate market. Property prices have since stabilised after a 2017 dip; but have still tripled in real terms since the mid1990s, lifting the price-to-income ratio to almost 30% above its two-decade average. Aggressive monetary policy tightening from the Riksbank can possibly cause havoc. Critics have since called for a rethink, but for now the Riksbank may have little choice but to stick to its guns. It is really stuck in a lowrate environment.
Impact
I am told bonds worth some US$17 trillion – about 25% of the debt issued by governments & companies globally, are currently trading with negative yields.
This means prices are so high that investors are certain to get back less than what they paid (interest plus principal) if they held the bonds to maturity. In effect, they are now paying someone to look after their money, instead of being paid an income by them. The spread of negative-yielding debt has raised profound questions about the extraordinary lengths central banks have gone in a bid to revive the economy over the past decade.
At the same time, bond markets’ journey through this “Alice in Wonderland looking glass” has befuddled many investors. So much so I think it’s getting insane. In Japan, NIRS first appeared in money markets about two decades ago. Since the 2008 financial crisis, they have engulfed government bond markets not only in Japan, but also in Sweden, Switzerland, Denmark and the eurozone – all economies grappling with low inflation, where the central bank has set interest rates below zero. Investors thirst for yield have forced them to look elsewhere, ensuring the spread of sub-zero yields, and dragging down borrowing costs everywhere.
As a result, oddities now abound: a Danish lender issued in late August a 10-year mortgage bond at an interest rate of minus 0.5%. That is, homeowners are being paid to borrow!
Meanwhile, Swiss bank UBS is planning to charge its super-rich clients for holding on to their cash deposits. Even large chunks of corporate bond markets now trade at sub-zero yields, including parts of the junk bond market (making a mockery of its “high” yield label). Emerging markets have not been immune either. Bonds issued by Poland, Czech Republic and Hungary have joined the club. Investors are now eyeing what could become the negative yield revolution’s next frontier – the biggest bond market of all: US Treasuries, the ultimate safe haven apart from gold.
Observed a friend at Pimco:
And, if the trade war keeps escalating, we may get there faster than you think. Investors are grudgingly adjusting in a universe where all interest rates are relative. If a central bank sets a base rate of minus 0.4%, a yield of zero on an ultra-safe government bond does seem attractive. If central banks keep cutting rates – as the European Central Bank (ECB) is expected to do this September – bond yields look likely to follow them lower.
The old theory that zero would act as a floor for interest rates has most certainly been shattered. However, most economists feel there is still some kind of limit – just lower than they had thought before. How low rates will eventually settle depends on at what point they start being counterproductive. In Switzerland, rates are currently at minus 0.75%.
At some point, savers will prefer to lock their cash in a vault rather than submit to punitive, negative rates. This means investors may not be able to ride the wave of negative yields much further. Then what? Indeed, what happens when rates go up? The game gets to be dangerous. Today, bonds have sub-zero returns out to 15 years’ maturity in Japan, France, Sweden and Belgium; out to 20 years in Denmark; 30 years in Germany and the Netherlands; and an astonishing 50 years in Switzerland. Indeed, Germany has become the largest economy where its entire yield curve is trading below zero.
Savings
Thrift has deep roots in the national psyche of Germany and Japan – even China. “Save our savings, Frau Merkel” is splashed in Bild (a German tabloid), calling on banks to spare thrifty Germans from “Strafzinsen” (negative penalty rates). German households’
€2.35 bank deposit totalled trillion, exceeding those in France and Italy combined. Last year, they squirrelled away 10% of disposable income, twice that of UK. There is even legislation proposing to ban negative interest
€100,000 rates on retail deposits of less than each. Such a ban is attractive for savers; but for financial institutions, it’s a burden affecting their profitability.
Already, the ECB charges -0.4% on bank deposits with it. German banks complain
€2.3bil they paid to ECB in 2018, about 10% of their profits. No doubt, banks detest negative rates. Still, fixed income investors (especially pensioners & the elderly who depend on income from their fixed deposit savings) need protection. They should not subsidise the rich borrowers and banks.
Will US follow?
The world is awash with about US$17 trillion of negative-yielding debt. This simply means that investors are sure to get back less than what they had paid, if held to maturity. German 10-year government bonds today yield -0.7%, while Japanese 10-year debt yields -0.27%.
Relative to its 1.5% yield, US 10-year Treasuries look attractive (it was 2% only a month ago). I can see it going below 1%; but negative Fed rates seems a very remote prospect. Sure, the Fed has left its door open for additional stimulus, but its target policy is well above zero (aiming at 2%–2.5%). As I see it, conditions in the US are looking fine today. For investors to ratchet their easing expectations higher, paving the way for the 10-year note to hit zero, the outlook for US growth will need to change drastically. This is unlikely in the next six months.
This summer, Alice in Wonderland came to the German housing market – yields on 5-year bonds issued by mortgage banks turned negative, to -0.2% (against +5% a decade ago). So, investors are prepared to pay for the privilege of lending money into Europe’s largest property sector – turning economic logic on its head. The same is happening in Denmark.
Indeed, yields on 10-year government bonds in France & Sweden had already fallen into negative territory, joining Germany & Japan. Strangely, neither politicians – nor voters – appear to really care. However, the mood is changing. Governments are beginning to realise that falling negative bond yields together with yield curve inversion have previously been good recession predictors. Moreover, investors’ psychology is also changing. Initially, negative rates were taken as reflecting idiosyncratic events and “oneoff” central bank easing. Their persistence and spread now point to long-term structural issues – even structural stagnation (when low demand and a reluctance to invest creates a self-reinforcing downward loop).
Then, there is the ultra-accommodative stance of monetary authorities whose balance sheets today carry really huge amounts of public and private debt. Bottom line: a growing consensus that NIRS are here to stay. The danger: exposes investors & institutions to nasty losses when rates rise – for whatever reasons, including political shocks. This growing risk in an Alice in Wonderland world needs to be reckoned with.
Inversion
A widely watched indicator of US recession is the inverted yield curve (IYC), i.e. when shorter rates (usually 2-year) are higher than long-term ones (usually 10-year). History has it that it preceded every US recession over the past 50 years.
This growing inversion reflected US investors’ scepticism that Trump’s more reconciliatory rhetoric in recent weeks will lead to a swift resolution of the Us-china trade dispute. What’s real is that traders have started to price-in more rate cuts as markets come to believe Fed policy is too tight. Germany is on the brink of recession; already growth forecasts in the Asia “tiger economies” have recently been slashed. Overall, the underlying trend remains firmly negative.
Still, controversy is there – some attribute falling Treasury market rates to weakness emanating mainly from abroad (hence, less concern at the Fed); while others blamed the IYC to concerns over the durability of domestic growth (highlighting the need for Fed to further cut rates). Latest events suggest a recession is coming; but can’t say when – can be as soon as a year from now, or could take as long as three years. What’s real is that money is flowing into US bonds that’s raising prices; hence, pushing yields further down. All these tells me that there’s a lot of pessimism about the future. On the IYC, here’s my take – the market is signalling the Fed’s short-term policy rate is too high; and can be fixed with a cut at its policy meeting this September. But weakness is not confined to the US, growth in India and China (the two engines of Asia) is losing steam. The EU, led by Germany, is also struggling with slowing growth.
More than 60% of countries world-wide now have contracting manufacturing.
So, investors – beware!
What then, are we to do
So far, NIRS are primarily a European (and Japanese) phenomenon. US bonds account for about 50% of the global investment grade bond market – they pay out 88% of all yields today. What do investors do to counteract the global yield drought: buy longer maturities or engage in riskier debt. But hunger for longer-dated debt has also pushed down yields sharply. That leaves venturing into the riskier corners of the bond market – into higher risk emerging markets; in heavily indebted companies, and in exotic, financially engineered instruments.
This can lead to other problems that will eventually create asset bubbles – something investors are already familiar. As I see it, investors are showing signs of caution despite their thirst for yields. The yield on triple-c bonds (the lowest rung possible without being in default) has started to decline (to 12% so far), lagging behind the rest of the junk bond market. There is, indeed, a growing realisation that the global economy is already in the late part of the cycle.
Still, hedge funds appear to be benefiting. Many hedge funds I know have still managed to find ways to turn a profit from the advent of sub-zero rates, trading NIRS bonds. One of the most obvious strategies involves simply riding the big rally. Yields fall as prices rise; managers who clung on to their holdings as yields tumbled below zero have reaped juicy profits. Among the biggest winners are computer-driven hedge funds that try to latch on to market trends.
While many human traders may question the wisdom of buying or keeping a bond that apparently offers a guaranteed loss, robot traders that monitor price moves have no such qualms. Nevertheless, some high-profile human traders I know have done well from the fixed income frenzy this year. Looking at negative yields can be a bit misleading. There are ways of making money from it. Yes, there are.
Professor Tan Sri Lin See-yan of Sunway University is the author of The Global Economy in Turbulent Times (Wiley, 2015) and Turbulence in Trying Times (Pearson, 2017). Feedback is most welcome. The views here are the writer’s own.