Central banks around the world have fallen all over each other lowering their benchmark interest rates. On Tuesday, the Reserve Bank of Australia was the latest, cutting its cash rate to an all-time low of 2.25%. It didn’t mince words: “A lower exchange rate is likely to be needed to achieve balanced growth in the economy.” A rare admission of escalating the currency war. The Aussie dollar immediately swooned.
Two weeks ago, the Bank of Canada suddenly cut its overnight interest rate by 25 basis points. Other central banks have chimed in. Japan’s rate has been at zero for years. “Negative deposit rates” have infected a number of central banks, including the ECB.
In this environment, the Fed is talking about raising rates from zero to next to zero, but the markets are not following its hints and are trying to force it to back off.
Ten-year government bond yields in Japan and Germany dropped closer to zero, before bouncing off in a sharp rally to 0.39% and 0.31% respectively. This is called the “Japanification of Germany.”
Back in August 2013, when 10-year JGBs still yielded around 0.8%, I wrote, Why I’m Deeply Worried About Japan – And Why Betting On The Collapse Of JGBs Is A Horrible Idea, which has become a leitmotif. Japan’s fiscal situation has deteriorated since, but JGBs have risen and yields have dropped, with shorter maturities sporting “negative” yields. JGB shorts have been kneecapped. Inflation is 2.4% as measured by the all-items index, and 3.1% for goods. Financial repression has become the rule.
The ECB is barreling down a parallel path, but at least in the Eurozone workers and consumers currently enjoy true price stability, though that is total anathema to central banks, most governments, the media, and corporations who have become dependent on using inflation for their own benefit. Since October 20, the ECB has bought €40.3 billion in “covered bonds,” which are backed by assets and guaranteed by the issuer. By September, in anticipation, covered-bond yields became negative.
It also bought €2.3 billion in asset-backed securities to push their yields down. Throughout, those who own these types of securities are watching their values balloon into the stratosphere.
So the ECB decided in January to buy €60 billion in government bonds a month. This decision had been expected for a long time. And government bond yields have turned negative in an increasing number of member states, for longer and longer maturities.
European high-grade corporate bonds have followed in lockstep. Nestle SA, the Swiss food conglomerate, might be the first company whose debt trades with a negative yield. Its notes, rated Aa2 and not even triple-A, due October 2016 were quoted at a yield of 0.05%, just a hair from zero, Bloomberg reported. Breaking below zero would be a logical step.
Notes that drug maker Roche Holding issued in 2009 and that mature in March 2016 traded at a yield of 0.09%. Whoever bought these notes in 2009 and sold them today made a chunk of money, thanks to the ECB. It’s “market-driven,” said Roche’s media relations head, Nicolas Dunant. The bond has become “increasingly attractive for investors in the current low-rate environment.”
The average yield of high-grade corporate euro bonds dropped to a record low of 0.987%. Less than 1%! At the end of 2013, the average yield was still 2.1%. They may be headed where covered bonds already are: Deutsche Bank’s home-loan-backed covered notes maturing in 2018 yielded a negative 0.03%. Mortgage rates in Denmark are already negative so that people are paid to take out mortgages; it’s fighting back in the currency war that the Eurozone has embarked on.
Investors are going to pay the price. But where else are they going to park their money? They’re going to pay for parking it at the bank, based on the negative deposit rates the ECB has inflicted on its banks that in turn have started to pass them on to their large depositors. The only hope for investors is that bonds will rise even further, with yields dropping ever deeper into the negative. This way, they might make money off the price, if they sell at the right time.
But how much longer can this absurdity go on?
“The basic logic is for yields to fall, but we must brace for widening volatility,” cautioned Kazuhiko Sano, the chief bond strategist at Tokai Tokyo Securities, at a January 27 event in Tokyo, according to Bloomberg. He’d predicted that 10-year JGB yields would drop to 0.5% by 2013 and to 0.25% by March this year. Ahead of his schedule, it plunged to 0.195% on January 20.
So now he sees the yield drop to 0.1% by March 2016, a good day away from going negative. The median forecast of nine economists that Bloomberg surveyed expected the yield to rise to 0.5%.
The Bank of Japan, by printing ¥12 trillion ($102 billion) a month to buy mostly JGBs, is monetizing over 90% of the new debt the government is issuing. It has become the relentless bid, and the JGB market has withered. The buying binge will drive down yields further, Sano said, but price swings could be wild: “Liquidity has shrunk so much that any selling could cause yields to spike.”
As I’m writing this, the 10-year yield has jumped to 0.39% – doubling in less than two weeks! Sano wasn’t kidding about wild volatility.
The potential for a slowdown in the EU could trigger a global recession and persuade the Fed to delay its first interest rate hike into the nebulous future. This would further pressure government bond yields, Sano said; “It’s hard to think Japan will be an exception.”
And 10-year Treasury yields could skid to 1%, despite the Fed’s rate-hike cacophony, DoubleLine Capital’s Jeffrey Gundlach has been saying since December. He’d nailed the plunge in Treasury yields last year, while most gurus thought they’d rise.
These ludicrously low yields, a phenomenon the world has never seen before, cannot be ascribed to the fear of a global recession. Global recessions are nothing new. But these yields are.
What these yields do show is that the markets for government debt, and increasingly for high-grade corporate debt, are completely controlled by central banks. There is no more price discovery. Risk has disappeared as a factor. The potential of inflation no longer matters. Any doubts are immediately pooh-poohed.
By throwing free money around that has to go somewhere,and by making leverage essentially free, central banks have catapulted asset prices into absurdity. They have created a mechanism by which governments and corporations can load up on debt without paying the otherwise normal costs of capital, and sometimes at an outright profit, while at the same time depriving those whose money this is – regular investors, pension funds, savers, and others – of a return. Confiscation comes to mind.
But there are costs. It saddles these governments and corporations with a future problem: debt doesn’t just go away. It has to be rolled over (or be paid off, a novel concept in these circles). But many of these entities cannot afford higher rates on their pile of debt. Then what? Force rates to or below zero forever?
It’s going to be tough. This is an economy where risks can no longer be priced, where the cost of capital is nil for some, and where price discovery isn’t handled by market participants but by central banks. Throw enough money at anything, and you’ll kill it.
So hedge-fund guru Paul Singer explains why they’re all buying these assets: a “wish not to be run over.” Read… Immensely Concentrated Positions in “Fantastically” Overpriced Markets with “Unlimited Tolerance for Risk”
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