Macro – Has the world gone mad?

by: Han de Jong

Macro-Weekly_Has-the-world-gone-mad_13-March-2015.pdf ()

More and more government bonds in the eurozone are trading at negative yields. And yet, when asked who will sell their bonds to the ECB, few market participants appear keen to do so. Has the world gone mad?

The US example

The ECB has started its QE. What will happen to yields in the eurozone? It is tempting to look at what happened in the US. The Federal Reserve started its first QE programme towards the end of 2008. The chart below shows that ten-year Treasury yields fell sharply around the start of that programme. Just what the doctor ordered. The graph also shows that yields quickly changed direction and rose during the first QE programme after the initial decline. By the end of the programme, yields were roughly the same as before QE1. Something similar happened during QE2. Now that the ECB has started its QE1 programme, the question is if core-European government bond yields will follow this example and head higher from here.

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Two differences

We don’t think so, at least not in a hurry and not to a significant degree. There are two big differences between the ECB’s QE1 and the 2008 Fed QE1. First, when the Fed started buying bonds the US government was running a budget deficit of close to 10% of GDP. Deficits in the eurozone are much smaller, Germany is even running a surplus. So the balance of net bond supply and central bank purchases is completely different. The second difference is that investors receiving dollars created by the Fed had a much broader spectrum of assets to invest their dollars in than investors receiving euros from the ECB.

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Negative for longer

These two considerations make it likely, in our view, that bond yields will stay low for longer under the ECB’s QE programme. How low? I do a daily count of the countries with negative yields in various maturity areas. For a while, ten European countries have had negative yields in the two-year area and a few others are less than a handful of basis points away from that. Until recently, some five countries had negative yields in the 5-year area, but that has now gone up to 9! I think negative yields at the shorter end of government yield curves could prove persistent for a while. The glut of liquidity is likely to continue to push down yields at the shorter end. Yields at the longer end are not only affected by what happens at the short end, but also how investors see economic growth and inflation developing and by the US bond market. As a result, we expect yields at the longer end of the curve to rise modestly later this year, but they will probably fall further in the near term.

The absolute low

I was recently asked how negative yields and interest rates can go in an adverse scenario. Economics text books do not provide the answer. Until recently, economists brushed the issue aside saying that rates could not really fall below zero as people would be taking their money out of the bank. People taking money out of the bank is, indeed, an effective barrier to interest rates falling lower. More recently, and forced by widespread negative interest rates at the short end of the yield curve, economists and commentators are taking a better look at this question. There are a couple of things to consider. First, storing notes and coins outside a bank and keeping the money safe costs money. Interest rates can thus at least fall as negative as the cost of safely storing large amounts of cash. This is estimated at perhaps 0.25%. A second consideration is that money in a bank is more convenient and actually more liquid than money in a vault or a hole in the ground. This convenience is also worth something. Based on credit card fees, economists appear to assess the convenience price of a bank account at 1-2%. A third suggestion popping up in discussions is that interest rates could gradually fall further and further into negative territory as people get more used to negative interest rates. A last thing to consider is that very short term interest rates are unlikely to fall below the ECB’s deposit rate, which currently stands at -20bp and which the ECB has vowed not to bring any lower. It is probably no surprise that 2 year German government bonds are trading close to -20bp (and even marginally lower, probably indicating that not all market participants have access to the ECB’s discount facility.) In an adverse scenario, however, the ECB might want to bring the deposit rate down further. My guess is that -2% is more or less the absolute low for interest rates. Please note that this is not our base-case scenario!

Who is mad here?

When people are asked why they think many investors appear willing to hold bonds with a negative yield, one element in the answer always is that many market participants hold on to the paper for regulatory reasons. A deafening silence then usually sets in as people nod, indicating that they find that a completely acceptable way of reasoning. This drives me mad. I may be odd but I think we should ask what that says about our regulations. Among other things, the laws and rules are there to safeguard stability and to protect individuals like me. I am a member of a pension fund and I have a life insurance policy. So part of my savings sit within my pension fund and the insurance company. And if I understand the whole thing correctly, most people agree that it is in my best interest that my savings are invested in negative-yielding assets. I have significant problems following that logic. But I seem to be the only one having such problems. What on earth is wrong with me?

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