The past week has been dominated by headlines about Brexit, while the financial world has speculated about the last meeting of the year for the Federal Reserve. The headline which caught my eye was “Australia issues debt at negative yields”. Actually, it was only short-dated Treasury bills which were offered, but nevertheless it means that another country joins the unenviable club of bond markets with negative yields. The figures fluctuate but at the last count the total stood about $18.5 trillion. This is a record high in dollar terms, more than doubling since 2017, although only about 25% of total bonds issued vs. about 30% in 2019. While the majority is government debt, there is a sizeable amount of negative yielding corporate debt too.
The process of bond markets drifting in and out of negative yields began when Japan moved to zero interest rates over 20 years ago. It picked up speed in 2014 when the ECB adopted its programme of negative rates. German 10-year yields – the benchmark for the whole of Europe – have been below zero since spring 2019. It may seem perverse to some to buy a bond with a negative yield, but after all it does offer certainty in an environment where much of the world looks very uncertain indeed.
Negative rates have attracted much criticism because of the damage they are perceived to cause parts of the financial system. They are a form of ‘tax’ on savers, generally the middle aged and elderly wealthy. Such a tax will be paid until there is a tipping point (the lower effective band in the jargon) when depositors might withdraw their cash. At the same time, negative rates undermine the ability of banks to lend, partly explaining weak money supply growth in Japan and Europe.
Central banks have responded. For example, the ECB has adjusted its approach, now using a two-tier system. The deposit rate on reserves at the central bank serves as a floor for money-market interest rates, providing an anchor for government yield curves. The lending rate on ECB long-term loan facilities means that, in effect, commercial banks can be subsidised to borrow 3-year money. The ECB regards this as successful; surveys report that European lenders see negative rates as having led to cheaper borrowing costs for customers and higher loan volumes, in effect driving monetary expansion in Europe. Others disagree, pointing to the weak state of bank balance sheets and share prices, as well as far lower rates of growth for household and corporate borrowing than lending to governments.
The world of negative bond yields also has implications for global capital flows, in effect a ball and chain phenomenon. Even in those circumstances where economic activity is picking up and inflation expectations are worsening, so it is difficult for the gap between those countries with positive and negative yielding bonds to grow too wide. At some point the spread is sufficiently attractive that an investor in one country will look to take advantage elsewhere. This has been a significant part of the arsenal of Japanese institutional investors for years, with periodic bursts of actively buying higher yielding US or Australian debt, often depending on currency movements to time their moves. More recently, European insurance companies have shown a similar approach, with a greater interest in buying higher yielding peripheral or corporate debt.
In the case of the UK and US, their central banks are unlikely to move the official interest rate structure into negative territory, unless either there is another major recession, or they are more certain that the downside risks for banking systems can be contained. Indeed, this week’s statement from the Federal Reserve focused much more on pledges to continue buying bonds until the economy makes substantial progress. Together with similar actions by other central banks, their balance sheets are collectively growing about 40% a year, the fastest since 2008-09.
The UK bond market remains well supported against this background, even without domestic concerns about the long-term scarring effects of the coronavirus or the possible drawbacks from Brexit. At the time of writing, the rise in the pound is an indicator that the financial markets do expect some form of ‘narrow’ deal at least around year end. Sterling’s appreciation will, inter alia, restrain import prices and keep inflation under control. The consumer prices index rose by only 0.3% in the 12 months to November, down from 0.7% in October, partly restrained by Black Friday sales. Even with the base effects of higher oil prices appearing in the data in 2021, inflation looks set to remains well below the central bank target.
To sum up, the weight of money around the world looking for a home with a positive yield continues to exert downward pressure on global yields, despite better news about the vaccine, a recovery in commodity prices, and the spate of forecasts about stronger economic activity into 2021.
Andrew Milligan is an independent economist and investment consultant. This note should be considered as general commentary on economic and financial matters and should not be considered as financial advice in any form.
Andrew Milligan an independent economist and investment consultant. From 2000-2020 he was the head of global strategy at Standard Life/Aberdeen Standard Investments, analyzing the major financial markets for global clients. He currently assists a range of organizations with reviews of their investment processes, advice on tactical investing and strategic asset allocation, and how to include ESG factors into their decision making