Are We Headed for Negative Yielding Treasuries?
With European rates being underwater for so long, and U.S. treasury yields really plummeting now, some are wondering how much longer the U.S. can stay positive.
Negative yields on bonds are a new phenomenon, and are completely counter-intuitive, as it should appear to be pretty odd indeed that people would lend money at a loss. A negatively yielding debt instrument involves exactly that, where you pay a certain price for a bond, and after collecting all of the interest payments it makes to you until maturity, you end up with less money than you started.
At first glance, we might see this behavior as not being sane, but it’s not quite as crazy as it seems, even though it does have some elements that we might at least call a little crazy. The craziness comes from this tactic being used as a tool for monetary policy, where central banks set their rates in the negative, which ends up setting the rates of their bonds below zero, and then they use quantitative easing to buy a lot of these negative bonds to further drive down their yields.
We read things like investors being willing to accept a negative yield in order to find a safe place to put their money, and this view can even come from people who we would hope have a better understanding of these things than this, as doing such a thing would surely qualify as insanity.
A central bank at least is striving for what they at least believe to be overall benefits to the economy when they do such a thing, which is to beat down the flames of a recession risk from a money supply under pressure. Monetary policy seeks to accomplish a single goal, to increase or reduce a country’s money supply to either keep economic growth moving forward or to slow it down when this creates too much inflation.
If money supply goes so low that central banks need to put rates below zero to try to stimulate it, they have a big decision to make, and it’s not simply automatic that they would choose to go below zero. Negative interest rates are no pleasure cruise, and are hated by savers since this affects the interest rates that they can get for putting their money in a bank as well as what they can achieve by investing in the negatively yielding bonds that result from this policy.
Both rate cuts and quantitative easing increases the money supply. Quantitative easing does this directly by the central bank’s creating money and using it to purchase bonds. This increases the demand for these bonds and puts their price up. Once the price rises enough above their value at maturity that the coupon rate, the interest that these bonds pay, is no longer sufficient to cover the capital loss at maturity, the rate of return or yield on the bond becomes negative.
This money goes into the economy and quantitative easing is the modern version of printing more money, although these days, only a tiny fraction of the money supply is actual money and the great majority of it is credit. The amount of credit in the system includes the borrowing that central banks do in order to buy these securities, as the bond market is also called the credit market, and this does serve to stimulate the economy to some degree.
Central banks don’t really borrow though in the same way that we do, because they don’t owe the money that they use for quantitative easing to anyone, and in fact have the bonds held as assets to offset their purchase price. As the value of these bonds go down, this creates a capital loss for them just like it does for us, but this is merely numbers on a balance sheet and we don’t worry about these things like we do fiscal debt which has to be paid back with interest, in theory anyway, even though governments can just keep on borrowing until they can no longer borrow enough to meet their interest obligations.
Quantitative easing also provides additional liquidity, which is essential for the financial system to keep running. Governments buy bonds, and the money goes into the former bondholder’s accounts, which are then used to provide more liquidity. The scary part of the financial crisis of 2008 was that, for a brief time, credit markets became illiquid, with banks being reluctant to lend to each other, and something like this can bring down the entire banking system if left unaddressed. This was an extreme example, but central banks pay close attention to liquidity every day and step in when it is reduced by an amount that they see problematic.
The tool that people focus on the most is the central bank’s ability to set the interest rates that they charge to lend to banks, and seeing this go below zero is something that they usually aren’t prepared to do. This is also done to increase money supply, and one of the ways that this accomplishes this goal is to allow for corporate bonds to be issued at lower coupon rates, allowing the companies to borrow more cheaply and stimulating the credit market that way.
This also stimulates the amount of loans that companies and consumers take out, once again due to lower rates. Central banks have a third tool at their disposal to control the money supply, the reserve ratio, and they can adjust this down so banks have to hold a lower percentage of the money that they lend out, although this one is rarely used since it increases the systemic risk of bank defaults if depositors become too eager to ask for their money back.
Reserves are designed to handle everyday withdrawal rates, and the fractional reserve system only works if most of the money is kept on deposit. If the reserve ratio is 10%, and more than 10% of the money that people have entrusted their bank to hold for them becomes recalled, the bank will fail unless the central bank bails them out. They don’t want to have to do that very often and certainly wants to avoid a run on banks in general, like what happened at the start of the Great Depression, so they only lower these reserves with much deliberation and as a last resort when their other two tools are not enough.
Without the intervention of monetary policy, our economic engine can run too hot or too cold and these periods can both become extended and dangerous. In both an expansionary and contractionary phase, levels of growth or decline can feed off of itself and lead to states of economic depression or hyperinflation, both of which are to be avoided.
Speculators Play a Key Role in Driving Down Bond Yields
The economies of Europe and Japan are both in a down cycle, and enough of one that their central banks have seen fit to put the rates that their central bank lends money to their banks in the negative. This, along with their quantitative easing, as well as the further upward pressure on bond prices by speculators, has caused German, Swiss, and Japanese sovereign bonds to run into the negative, although this isn’t automatic and depends on other factors such as how much bond buying central banks are doing as well as how market participants react to this.
Since it is the aggregate demand for these bonds that set the price, it isn’t just central banks running their prices up by increasing demand through their quantitative easing, as the other players weigh in as well. We can understand why central banks may buy negative yielding bonds, but why would anyone else want to?
There could come a time where the financial system becomes so damaged that it could make sense to choose negatively yielding bonds as a hedge, with everything else on the brink of collapse, including the banking system, but we’re nowhere near this. We did come close to such a thing in 2008, but there’s lots of liquidity in the system and there’s nothing on the horizon to suggest this won’t continue. We’re also very far away from the risk of massive widespread defaults, like we saw in as well in 2008, so this is not about seeking out a haven that loses money because you need to do it to be safe.
To go along with this demand that central banks create, some big institutional funds have a requirement of maintaining a certain percentage of their funds in these bonds, and are therefore forced to keep buying them whether it makes sense to or not. This is not an efficient way to force someone to act though and we should not have regulations like this which harm investors by commanding them to invest in losing propositions, but nevertheless, they remain. The goal of these regulations is supposed to be to protect investors but they did not contemplate negative rates and this is in need of rethinking now.
On top of this, bond traders see bond prices rising and may wish to speculate on their prices rising further. We have a situation where both central banks and funds are artificially raising bond prices, and as traders jump on to piggyback on this effect, this increases demand further and drives prices up further as well, and yields further down in turn.
These traders do not care about yields because they are not in it to collect income or hold anything any longer than it is profitable for them to do so. If you buy a bond with a zero yield and the yield goes down, and you sell it at a higher price and lower yield, you make money, and a lot of money is made this way.
It therefore makes sense for yields to turn negative, although when this happens, this leaves individual investors out in the cold, the ones that wish to use these bonds for income. Those who like to use U.S. treasuries for this purpose have become greatly disenchanted with the low yields of today, record low yields, but as long as the yield is positive, they are at least not choosing a plan that is designed to lose. When yields go negative, this is what they would be doing, if they plan on holding them to maturity that is.
We do need to realize though that the purpose of sovereign bonds is not to provide an investment vehicle for income investors, even though people may choose to invest in them if they find the circumstances appropriate. There are bigger fish to fry than this, and this particular fish of theirs isn’t even in the pan.
Investors being swayed away from bonds due to low or negative rates is therefore not one of the downfalls, even though in a democratic system, politicians may take these complaints seriously enough. The same is true with savers complaining that interest rates are too low, or even banks complaining that they can’t make money with rates this low.
Instead, these things are aimed at the money supply that we’ve been talking about, and if this is the goal, these other considerations just won’t matter. Central banks are independent of the political process, which is necessary lest the electorate be allowed to steer us on a dangerous course with no idea about what they are doing.
There are economic consequences of negative rates though, and this has to do with default risk. As rates go lower, default risk is actually lessened, because it is now cheaper to borrow and your ability to pay back debt is increased. Rates do need to be put up at some point though, when the economy picks up enough that these low rates end up not being matched with the circumstances and become too inflationary, and this is where the pain occurs.
What happens then is that people struggle more to pay back debt at a higher rate than was in place when they borrowed the money, and the amount successfully paid back becomes reduced. Nothing reduces money supply more than credit defaults, because this puts down the amount of credit in the system and the amount of credit out there and the money supply is basically the same thing.
Negative Rates Can Help, But Come at a Real Cost Later
We therefore need to tread carefully when we decide to put rates down, as it’s not just a matter of improving things now. We also need to account for the price that will be paid for this down the road as this eventually causes inflation to rise too much, and we can’t just let inflation run wild as this is too dangerous.
We are then left to choose between evils, and it turns out that the evil of a recession is lesser than the evils of hyperinflation, so central banks are forced to raise rates. In a real sense, we are just deferring recession risk from now to some point in the future when we put rates down, and especially when we put them into negative territory.
The U.S. Federal Reserve has never chosen to put their rate below zero, and they stuck to their guns throughout the financial crisis of 2008. However, treasury prices are affected by more than central bank interest rates, and the positive gap between treasuries and other sovereign bonds have really stimulated demand for treasuries these days.
This is the real reason why treasury yields are so low these days, and this has very little to do with fears of a recession or the coronavirus. The Fed cutting interest rates by a total of 1.25% lately certainly contributes to this, but rates were at zero for several years not that long ago and treasury yields are much lower now than they were.
This does serve to reduce this gap though, so it’s not as if this latest half of a point will be added to the existing demand, and does serve to reduce organic demand for treasuries at least somewhat. It also weakens the U.S. dollar, and one of the big attractions for U.S. treasuries is that they are dollar denominated, so this will turn down demand somewhat as well.
We’re now sitting with yields on treasuries substantially lower than they have ever been in history, although that’s only the case with certain treasuries. The yield on the 1-month note had dropped all the way to 0.01% back in 2010, and it’s at 0.79 now, even though it was at 1.41to start the week, to show how much things have come down over the past few days.
If we are wondering about the chances of treasury yields going underwater with any of the issues, this experience with the 1-month note can be seen as instructive. The treasury market simply refused to put this to zero even though it came as close as we could get to it. The reticence for negative yields with U.S. treasuries is much stronger than with bonds from other countries.
A big part of the reason for this is that the Fed doesn’t pile on treasuries in the same way that we’ve seen this in Europe and Japan, and there is a strong will to keep both the target interest rates and treasury yields no lower than zero. Not doing so is in a real sense being willing to visit the dark side, with plenty of undesirable consequences, and it’s just better to not go there.
Central banks do have the ability to step in and halt these things if they wish, apart from choosing to no longer be part of the problem by stopping easing. They can use quantitative tightening instead, selling some of their bonds to the market and increasing supply to keep yields from falling into the negative. This is not a matter of relying on which way the wind blows, as hard as it is blowing now, harder than at any time in our history.
There’s also the fact that demand is so high for treasuries because they have a yield that is so much higher than elsewhere, and this effect diminishes and even may disappear as rates approach zero. This places upward pressure on yields, and will also serve to chase away the bond speculators who no longer see prices moving their way as this effect materializes.
The Federal Reserve is also significantly more powerful than other central banks, and therefore have more control on where things go. As well, with the voracious appetite that the U.S. treasury has for borrowing money, an appetite that is increasing dramatically every year, this will assure that plenty of supply will be maintained in the market to cushion increases in demand from all sources.
The closest we are to negative yields right now is with the 1-year, which has really felt the brunt of current market conditions. On February 20, around the time that the coronavirus fears really started to hit the market, it had a yield of 1.46. On Friday, this yield had dropped all the way down to 0.39%.
Things are expected to level off now given that the half point rate cut has been fully priced in, and as reality sinks in more and the fears of this virus dissipate, this will serve to send this and other yields back up. Until then, with yields dropping at such a shocking rate, we are already in territory that no one thought possible, so this will bear watching closely.
U.S. treasuries are under more buying pressure than we have ever seen in history right now, and if even the events of late cannot get us into the negative with any of these issues, we have to wonder what would. This coronavirus panic that we’re seeing now is like nothing else though and we are at the point where negative yields are at least in the realm of possibility.
We may never get back to the rates of today in our lifetimes, if ever. The current upward trend in prices and the accompanying downward trend in yields could go on for a little longer, but this is a market that does not have an appetite for negative yields, and this huge move to U.S. treasuries lately is all about avoiding negative yields, not being comfortable with them.
Plenty of bond investors shy away from low yields and especially will do so when rates approach zero. The demand stimulus from this also declines right along with declining yields, and will completely disappear if we ever get to zero, as the only reason to want to hold them at this point is for short-term price speculation, which these investors do not engage in. This will also serve to strengthen the floor that is at zero yield.
No one really can predict the future, but treasuries can be expected to put up a considerable fight to keep from going under. The Fed could step in, but given how much they are trembling right now, that’s far from a sure thing. The combination of the high degrees of both speculation and fear have shown to be pretty potent indeed as we inch lower and lower each day now.
U.S. treasuries are quite different from the bonds issued by other countries, and these differences are among the reasons why treasuries are so popular. Plenty of people may fear and even expect them to go negative, but not those who realize how strong the tide actually is against this. This could happen, but it’s more unlikely than some may think.
Editor, MarketReview.com
Robert really stands out in the way that he is able to clarify things through the application of simple economic principles which he also makes easy to understand.
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