By Cliff Noreen
Negative nominal yields are becoming more pervasive in the government bond market. Most developed markets in Europe have negative two-year yields while more liquid developed markets like Japan teeter near 0% and Italy, the U.K. and U.S. offer seemingly outsized yields by comparison at less than .65%. Investors are now paying governments for the privilege of lending them money. Why would they do this?
This seemingly irrational practice may reveal more about current investment attitudes toward safety, deflation and currency values than anything else. Additionally, it serves as a commentary on the weakened state of European economies. Just how long it takes before economies begin to normalise remains to be seen.
If investors view downside risk as outweighing upside potential, they may seek a safer investment with a quantifiable small loss as opposed to the potential for larger losses. Banks may view certain negative government yields as more favourable alternatives to even more negative deposit rates imposed upon them by their central banks. Across Europe, several central banks have moved their deposit rates into negative territory. Within the ECB’s quantitative easing (QE) programme, funding government bond purchases with a -.2% deposit rate can create a positive carry if the central bank buys bonds with slightly higher (though still negative) yields.
Investors who are concerned about or expect a deflationary environment may also find negative yields attractive. A negative nominal yield could result in positive real (inflation adjusted) returns if prices continue to fall. In this situation, the purchasing power of money increases as prices decline. However, this does not send an encouraging message about growth prospects as economic activity should slow in anticipation that goods and services will be even cheaper in the future. Deflation has historically been very damaging to economies.
The paradox of QE is that central banks actually want to accelerate growth, eventually moving yields higher. While buying government debt in size would send prices higher and yields lower, the real aim is to increase growth and economic activity, which translates to higher expected levels of inflation and thus, rising real yields. Therefore, one of the key variables to monitor is inflation expectations. It appears investors are currently unconvinced it will work in the Euro area as inflation expectations have fallen steadily since February 2012 and declined again following an initial uptick after the ECB’s January QE announcement. The further out on the maturity scale that negative nominal yields exist, the more embedded deflation and low economic growth prospects can become. Particularly disconcerting are Switzerland and Germany, which currently have negative government bond yields out to ten-year and six-year maturities, respectively.
Currency values are another important factor as to why investors would consider a negative-yielding investment. A rising currency can offset a negative nominal yield. In the case of Switzerland, its two-year government yield was modestly negative in mid-January when the Swiss central bank abandoned its peg to the euro. International investors that captured the sharp appreciation in the Swiss franc would have more than offset the negative yield on the bond. The sharp and swift strengthening of the US dollar (+21%) over the past eight months and concomitant decline in the euro (-20%) has created volatility in the currency markets and prompted responses from various central banks to make difficult choices on whether or not to support their currencies.
The world of negative yields creates a highly unusual environment where you get money for nothing, but risk for free. It is during these times that return of capital likely trumps return on capital. Investors are now faced with fewer choices to achieve risk-free returns and more alternatives to deliberate return-free risk. If central banks are successful and the global economy returns to a more “normalised” environment (i.e. higher growth and inflation expectations), losses on government bonds could be significant. In the meantime, investor views on safety, deflation and currency values in a negative-yield world should continue to drive the direction of interest rates and bond returns.
Cliff Noreen is president and managing director at Babson Capital
Comments