Over past week one of the most interesting phenomenon I have seen in global economics has come to pass: investors (primarily in Europe) have decided that the world’s economic outlook is so grim that they are willing to park their money in negative-yield financial instruments. This was supposed to be an irrational decision, by traditional economic logic. After all, who in his right mind would invest a financial product that was guaranteed to lose money?
However, as The Economist noted, this is exactly what is happening in European bond markets:
A GUARANTEED loss. That is what investing in bonds at negative yields implies: those who buy the bonds will get back less than they paid even after interest is taken into account (and some will have to pay tax on the income as well). Yet government bonds of various maturities in as many as ten countries are selling at negative yields. Why on earth would bond investors, the “masters of the universe” once famed for intimidating governments, be willing to accept such a lousy deal?
One obvious reason is fear, or at least caution. In the depths of the financial crisis in 2008, when the safety of the banks seemed in doubt, short-term Treasury bills offered negative yields and investors were happy to take them. (Holding physical cash is impractical, given the sums involved.) Now, with some uncertainty about what might happen to banks were Greece to leave the euro, investors may decide it is worth accepting a negative yield of 0.16% on two-year German bonds. “In effect you’re paying a 16-basis-point custody fee for keeping your money safe,” says David Lloyd of M&G, a fund-management group.
As the FT further notes, this trend is not an isolated one but is actually increasing:
Once a rare phenomenon, such securities are becoming more common. The universe of negative yielding bonds in Europe has ballooned from $20bn to $2tn in less than a year, according to JP Morgan. Five-year debt issued by countries such as Denmark, Finland, the Netherlands and Austria all trade at negative rates while corporate debt issued by companies such as Nestlé and Shell has also traded in negative territory.
There are several theories floating around explaining a phenomenon that was once thought pretty much impossible:
1) European investors hold a truly dismal outlook on the future of their economy. As The Economist also noted: “The euro zone is struggling to generate growth and faces a poor demographic outlook, with the workforce in many countries either stagnant or set to fall.”
2) Investors believe we are entering a long-term deflationary period with steadily falling prices. In this scenario. holding bonds with a slight negative-yield would actually make you money in the very long run.
3) Investors believe that currency shifts will overcome any losses incurred by the negative bond yields. The Economist thinks that the revaluation of the Swiss Franc may be stimulating this line of thought:
International investors who bought Swiss bonds before the Swiss franc’s recent jump (it rose 30% against the euro in minutes after the central bank abandoned its exchange-rate cap and ended the day 12% higher) will have made a killing.
Believers in the theory of purchasing-power parity think that, over the long run, exchange rates adjust to account for price differentials. A country with a relatively high inflation rate will tend to see its currency depreciate; a country with a low inflation rate will see its currency rise. So international investors who expected to see the Swiss economy suffering a long period of deflation might accordingly expect the Swiss franc to rise steadily, and thus be willing to hold its government bonds.
4) The final and most plausible theory is that investors expect the European Central Bank to start its own bond buying spree in the spring to stimulate the European recovery. As the FT explained:
The central bank plans to start buying massive amounts of bonds in the coming months in order to jump start the eurozone economy.
Hence there is a very good chance bond yields will fall further into negative territory as the ECB and other central banks buy up huge amounts of debt. That will push prices higher and means investors will reap a capital gain that offsets a negative yield.
While negative bond yields are a compelling sign of a serious dysfunction, bond investors see an opportunity for capital gains or what is known as a positive total return. That is what makes bond investors very happy.
There is at least logic to this position, but, if true, it’s telling that the top financial managers in Europe can find no better way to use their money than to take a negative-yield position in the hope a government institution’s stimulus efforts creates a positive return for them. Is there really no more productive way to invest the more than two trillion dollars (equivalent to about 14% of nominal European GDP) that has already been poured into negative-yield bonds? Furthermore, as The Economist also notes, this is not even a risk-free proposition:
If the global economy returns to normal, then losses on government bonds will be substantial. The same would be true if inflation ever reappears. M&G says that if German bond yields merely rose back to the levels that prevailed at their previous trough, in 2012, when it was feared the euro might break up, investors would suffer a capital loss of 7%. Whatever else European government bonds may be, they are not risk-free.
Perhaps there is no better option for this cash than to be bet on an ECB buyout in a few months. Once again, this hardly seems like the most productive use for Europe’s capital. Indeed, recent research show that a huge amount of investment capital that should have been deployed in Europe by now is basically missing. For example, a recent IMF working paper (by Bergljot Bjørnson Barkbu, S. Pelin Berkmen, and Hanni Schölermann) concludes that: “Overall, controlling only for output, the cumulative unexplained shortfall in investment is about 3–6 percent of GDP (excluding Spain).” Yet, even in Spain, one sees this phenomenon in effect. In fact, I was in Barcelona last week speaking with a friend who is exporting advanced Spanish building materials and methods to Latin America. His business is booming, but its expansion is being financed by South American capital which, despite its higher cost, is easier for him to access.
In the end, then, rather than finding ways for European capital to be put to work creating new innovations or growing already successful businesses, it is being parked in financial instruments that, on paper at least, guarantee a loss to the investor. While the short-term logic of these positions is (perhaps) understandable, one would think that the ECB, and European governments, would work to find a better place to channel these funds. As Nouriel Roubini writes on Project Syndicate:
…central banks and fiscal authorities need to pursue policies to jump-start growth and induce positive inflation. Paradoxically, that implies a period of negative interest rates to induce savers to save less and spend more. But it also requires fiscal stimulus, especially public investment in productive infrastructure projects, which yield higher returns than the bonds used to finance them. The longer such policies are postponed, the longer we may inhabit the inverted world of negative nominal interest rates.
In other words, rather than just pushing down interest rates into negative-yield territory, policy makers should find worthwhile projects into which all this cash can be directed in a productive manner. After all, it’s hard to believe that in all of Europe there is no better place to deploy two trillion dollars’ worth of Euros than nagtive-yield bonds. In fact, a small country on the Mediterranean with sunny beaches and a wonderful history comes immediately to mind.