Negative yields – a fascinating situation


  • Business
  • Saturday, 28 Mar 2015

I AM often asked: what’s NIR – negative interest rate?

How does it come about? Indeed, how can it even happen? For most, the concept is counterintuitive. Logically, why would anyone buy something with a negative yield; that is, for an investor to pay out more than he gets back?

To clarify: why would anyone want to lend money for a negative return (i.e. pay the bank for accepting your deposit or pay the borrower for accepting a loan) when you can simply hold on to the cash. It’s a fascinating situation. But that’s exactly what’s happening in eurozone, Switzerland, Denmark and Sweden.

Not just for short-term rates. About US$3 trillion of “papers” with maturities as long as 10 years in Europe and Japan (e.g. Swiss government bonds) now carry NIR. You now pay the borrower instead of the other way around. Already, investors (savers) do accept negative returns for the convenience of holding cash balances (in bank current accounts). In this sense, there is nothing new or unusual about NIRs.

Simply put. Today, we live in a world in which there is just too much supply and too little demand. So prices fall. This is happening to oil and commodities, wages and housing, consumer prices and incomes. Today, there is just too much savings chasing too few productive investments, resulting in severe falls in interest rates. Supply of funds continues to far outstrip demand reflecting the impact of QE – quantitative easing (central banks buying bonds); first in the United States and UK, then Japan, and now Europe – flooding the world markets with lots of money. Interest rates have fallen sharply and have begun in some nations to turn negative – after being near zero for most of the past six years.

NIR assumes two forms: (i) actual negative rate of interest being offered for bank deposits and bonds; and (ii) negative rates in “real terms” (i.e. very low or zero rate of interest adjusted for inflation). This means that a year from now, cash balances at the bank will buy less goods and services than they do today. And if you consider the fees and charges imposed by the bank on accounts with it, the “effective” nominal return has become negative even before the big central banks started to debase their currencies, which got rates to become negative in the first place.

European NIR

Torrents of money created by QE conducted from ECB (European Central Bank) are causing a major shift in the flow of money around the world, driving down the euro at a rapid clip. As I write, euro has fallen 22% against the US dollar – touching a 12-year low of below 1.05 euros. The ECB is holding down interest rates to nearly zero and the rate it pays for banks’ deposits to below zero since last summer. This year it started QE (at 60 billion euros a month) whereby it prints euros to buy European bonds. Such purchases have driven up bond prices (which vary inversely with interest rates) as rates fall, pushing bond yields to record lows.

German 10-year debt today yields only 0.18% p.a. and German bond yields are negative for maturities of up to 7 years. So, NIRs offer investors a guaranteed loss on their money if they held the bonds to maturity. Germany has followed Finland in selling 5-year debt at negative yield. Investors pay 100.39 euros per 100 euros worth of paper with no income payments, thereby accepting a yield of minus 8 basis points on their money. Today, more than 25% of the entire European government bond market has yields below zero – totalling US$2 trillion. Historically, sub-zero yields were confined to very short-dated bonds in the secondary markets. But as the momentum grows, nations like France, Finland and Germany have succeeded in selling vast amounts of negative yielding bonds with maturities of up to 5 years so far this year.

Negative yielding bonds refer to bonds in which the price paid is higher than what the investor will get back over the lifetime of the bond in coupons plus repayment of principal. In some cases, no coupon is offered. When Finland sold 5-year bonds with a 0.375% coupon, the price paid was high enough to make the yield negative.

So, why do investors accept the loss? Because they fear greater loss elsewhere. However, falling inflation and possible deflation make fixed income bonds more appealing in real terms. Furthermore, investors hope to benefit from later currency appreciation from Danish, Swiss, Norwegian and Swedish bonds.

Here’s an anomaly. German savers prefer to rake in only 0.5% (in Germany) than earn 2% (Portugal) on their savings! Interest rates, for both deposits and loans, differ widely even among eurozone nations – the same bank pays depositors different rates in different countries. Deutsche Bank offers 0.56% for 1-year euro deposits in Germany but 1.29% in Italy. In theory, such a difference would disappear through arbitrage as banks move money from cities where there is an excess of savings to spots with under-supply.

After all, there is a national guarantee on deposits of up to 100,000 euros. In practice, however, local regulators impede this, despite ECB overseeing all euro-banks and investing across borders is easy. Germans stashed about 2 trillion euros (55% of GDP) in bank savings and term deposits in Germany (most steer clear of investing in houses and shares) at far lower rates than in Italy (best offer at 1.3% for 1-year deposit) or 1.65% in Poland (with a higher credit rating than Italy). Supposedly rational Germans do get emotional about their money!

US yields

Little by little, US Fed chairman Janet Yellen is acclimatising to the prospect of a gradual turn in the US interest rate cycle. She has since dropped the words “being patient” in raising rates from near zero in its policy guidance in favour of the new buzzword in “feeling reasonably confident” that inflation is on the way back to the 2% target before any rate lift-off. For her, four targets now matter: jobs, jobs, jobs; wage growth; core inflation; and inflation expectations.

Labour markets still need to further improve. Wages have to break-out of their lethargy. Inflation (ex-food and energy prices) need to stabilise. Investors and household expectation of inflation has to improve. As of now, Yellen remains confident about the sustainability of the US recovery. But she is right in being cautious about downside risks.

As I see it, the Fed’s watchword continues to be being open-minded. Yellen sees a crucial part of her job as managing expectations. As things stand today, money market futures traders rate the likelihood of a rate rise (from near zero) at 40% in mid-March 2015, a fall from 55% in December 2014. The market now expects the median federal funds rate to fall from a December 2014 forecast of 1.125% to 0.625% by end-2015.

As the Fed wants to continue providing support to sustained recovery (growth forecast since being downgraded to 2.5% for 2015), the process towards rate normalisation will be slow. Another year stuck along the weak “new normal” growth path that began in 2009.

Sure, the S&P 500 has reached record heights and unemployment is down to 5.5%. But real median household income has fallen to US$52,000 in 2011-13 from US$56,000 in 2007, despite powerful QE operations over six years and near zero interest rates. “Core” CPI (consumer prices) that strips out food and energy, rose 1.6% year-on-year in January 2015, while headline CPI fell 0.1% in the same period (reflecting falling oil prices).

After years of QE, I sense the Fed still believes that growth has to come from private-sector dynamism which can only emanate from market pricing and not artificially low rates. Normalising interest rates is critical. It needs to start from small rate hikes to spur loan demand (to be ahead of rate increases), and incentivise savings and lending activity. More important, it needs to “unfreeze” the moribund inter-bank market and begin to unwind the Fed’s take-over of the market’s central role in capital allocation.

At zero rate, the market has since lost its benchmark role as the credible market arbiter of efficiency. Whenever the Fed is ready to start tightening, the trajectory of rates is unlikely to be steep. A decade ago, the so called “Greenspan ladder” led to 17 consecutive small interest rate hikes in the last full business cycle. So Yellen is bound to be cautious – hikes will be incremental, with occasional pauses whenever the economy softens. Her aim is to put in motion a years-long process of getting overnight rates off near zero towards the region of 3.75% that she considers “normal.”

It is noteworthy that long-term US Treasury yields are today far lower than a year ago. The “term premium” on 10-year notes (that is, the extra compensation investors demand to hold them over cash) has fallen to negative, bringing it to its lowest level in 50 years. The Fed’s dilemma: it doesn’t want its first rate hike to unnerve the markets and put economic growth at risk (remember her target: jobs, jobs, jobs). Yet, it also doesn’t want to delay acting just because that might knock pricey assets lower. So Yellen has to move smartly – hold tightening at bay for as long as is tenable and pushing markets to get used to adjusting and getting comfortable with the idea of higher rates.

What, then, are we to do

Over time, the idea of NIRs is to lead savers to save less and spend more. The danger is that in the event advanced economies do sink into secular stagnation (as Europe is close to), NIRs at both the short and long ends could become the new normal. To avoid this, monetary stimulus (reflecting massive QEs) needs to be accompanied by short to medium term fiscal stimulus. Resolving this mismatch is critical to jump-start growth and induce positive inflation, especially in Europe and Japan.

It is incredible that the eurozone, US and Japan are still pursuing varying degrees of fiscal austerity at this time. In the process, monetary policy is being pushed to its hilt without fiscal support. It’s about time fiscal policy pulls its weight. Even the IMF is now pushing for greater public investment in infrastructure. With zero interest rate, the case for massive infrastructure spending is indeed compelling. Without change, present policies serve to perpetuate continuing slow growth (if any), even secular stagnation (if status quo remains), disinflation and deflation (possibly).

The longer nations postpone decisions for a better policy balance, the longer NIRs will persist to paradoxically induce savers to save less and spend more. In such a convoluted “risk-off” environment, where investors become more risk adverse and where equities and other risky assets are subject to rising uncertainty, savers feel better-off holding NIR bonds than being exposed in holding volatile assets.

 

Former banker, Tan Sri Lin See-Yan is a Harvard educated economist and a British chartered scientist who speaks, writes and consults on economic and financial issues. Feedback is most welcome; email: starbiz@thestar.com.my.

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