How Is Negative Yielding Debt Possible?
Currently over $9 trillion bonds are trading with negative yields in the open market. Most Euro zone government bonds up to 5 years are trading with negative yields and it seems that this madness in the markets could continue forever.
The question you’d probably ask yourself is: “how did we get here and who are these people buying bonds that’ll guarantee losses in the future?”
Well, the answer to that is not as complex as it seems. If we review the policies conducted by global central banks post-Lehman we see unprecedented amounts of liquidity being pumped into the system. This occurred because of liquidity shortages during the 2008 financial crisis caused by uncertainty in the inter-bank market as banks ceased lending because they were skeptical about each others balance sheets. Besides targeting the rate of inflation most central banks also act as lender of last resort.
It is important to note that Quantitative Easing (QE) was NOT the reason why nominal interest rates went negative as some have suggested. In fact QE can impossibly push nominal rates negative. Commercial banks are required to deposit excess reserve at the central bank. It was the rate at which commercial banks park excessive reserves at the central bank, in the euro area called the ‘deposit facility rate’, that sends rates negative. In the US for example, commercial banks still get paid to hold excess reserves at the Fed, this clarifies why nominal interest rates never went negative in the US.
Because the ECB controls short term interest rates, this policy change resulted in the Eonia or Euro overnight index rate (the rate at which Euro area banks borrow excess liquidity from each other) inevitably moving in negative territory. Obviously this rate is substantially higher than the one on the deposit facility rate because of the risk premium involved.
Who Is Buying Bonds That’ll Guarantee Future Losses?
When borrowing money from the ECB, commercial banks are required to offer collateral. This collateral gets treated with what we call ‘a haircut’.
For example, if a commercial bank wants to borrow 5 million from the ECB and offers €5 million worth of German 10-year bonds as collateral, if the asset gets a 10% haircut that means that it is treated as if it is worth €4.5 million. The percentage of the haircut depends on the risk and liquidity of the asset. This is why commercial banks buy these negative yielding bonds, not because they can profit from them, but because they can use it as collateral to borrow from the ECB. This system contributed to the debt crisis in Europe by enabling sovereigns to borrow money at low yield as the euro banks would guarantee the funding regardless of the risks involved.
Source: Europe Central Bank
Countries like Denmark, Sweden and Switzerland also have negative nominal interest rates, but not for the reasons that I mentioned above. These countries are namely trying to peg their currency to the Euro. QE and Negative interest rate policy (NIRP) by the ECB resulted in upward pressure on the exchange rate of those countries, to prevent their currency from appreciating any further they had to intervene.
I wouldn’t suggest that the end of negative yielding securities is near. This would signify that the ECB is ready to reverse its interest rate policies. With headline inflation well beneath the official target (1.5%) I don’t see why they would reverse their policy anytime soon. Perhaps we could see a first interest rate hike in 2019. The markets anyway aren’t pricing in an interest rate hike in 2018. There is a lot of pressure on the ECB to bring the deposit facility rate to a positive environment to prevent asset prices from going wild, but Mario Draghi and the governing council are very committed to their mandate which is “price stability” which is an oxymoron when the defined target is inflation close to but beneath 2%.
Sooner or later, the path of higher rates will arrive and that could be a significant headwind for the eurozone economy, whether the catalyst is demographics or sovereign instability like Italy is to be determined. What cannot last forever, will not, but it can certainly last longer than we anticipate.