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The spread of negative yields

More and more bonds are yielding less than zero even in nominal terms, and investors expect this to remain the case
August 13, 2019

Investors are paying European governments to borrow money. In the eurozone. AAA-rated bonds with maturities of less than 25 years now have negative yields. And in Switzerland, even 50-year yields are now below zero.

This tells us something big – that investors think negative yields are not merely a temporary artefact of cyclical economic weakness but are in fact here to stay.

Yield curves tell us this. According to the European Central Bank (ECB) AAA-rated bonds in the eurozone with a five-year maturity now yield minus 0.83 per cent, while their 10-year equivalents yield minus 0.54 per cent. This implies that investors expect five-year yields to be negative (minus 0.2 per cent) even in five years’ time. Sub-zero yields, then, are not just a cyclical thing.

Instead, three other things are going on.

One is that there has for years been a shortage of safe assets. Very few governments or companies can issue AAA-rated bonds but savers worldwide – many of whom face not just economic volatility but political uncertainty too – want them. The upshot has been rising prices of assets such as Swiss and German government bonds.

Another is that fears of continued slow long-term growth have pushed investors into assets that protect them from the prospect of ongoing stagnation.

Thirdly, much of central and northern Europe now has a massive savings glut. One simple measure tells us this: current account balances, as these are the excess of domestic savings over domestic capital spending. According to the Organisation for Economic Co-operation and Development (OECD) Germany will have a surplus this year of $286bn, or 7.3 per cent of GDP. The Netherlands will have a surplus of 11.1 per cent of GDP, Denmark 6.7 per cent and Switzerland 9.6 per cent. We’d expect big savings to push down bond yields.

These last two facts are related. It’s plausible that the same ageing population that is boosting savings is also contributing to the economies being less dynamic.

For equities, such low yields are a mixed blessing. On the one hand, the prospect of certain losses on bonds if held to maturity is driving some investors to seek higher returns by buying shares: this is the so-called “reach for yield”.

But this is dangerous. It means that any sign of higher than expected interest rates would cause shares to fall if investors fear that the reach for yield will go into reverse. As we saw with last year’s drop in the S&P 500, even a slight hint of rising rates can hit shares hard when they are supported by cheap money.

To guard against this danger, remember a trivial principle of equity pricing – that a fall in the discount rate applied to future cash flows should not raise share prices if those expected cash flows also fall. Insofar as negative yields are a response to slower future growth, therefore, they should not boost equities.

For those of us whose mindsets were formed in the 1970s and 1980s when nominal yields were high, negative ones seem weird. We should resist this feeling.

The notion that yields should be positive rests on the belief that people need to be rewarded for saving, for delaying gratification and postponing consumption. Back in the 1980s, when people were younger, poorer and were borrowing, this made sense. Today, however, the massive current account surpluses in northern Europe tell us that people want to save a lot. And if enough people want to do something, there’s no need to give them incentives – and indeed a reason to disincentivise them.

Negative yields are not unnatural. They are – for the most part - the product of market forces (yes, quantitative easing helped reduce them, but this doesn't explain their latest slide into sub-zero territory). 

What, then, might raise yields? In theory, there’s an obvious possibility – for governments in the north of the eurozone – to absorb excess savings by relaxing fiscal policy. If this is sufficiently expansionary, monetary policy will have to tighten and the prospect of higher short-term interest rates will raise bond yields. As Oxford University’s Simon Wren-Lewis and Jonathan Portes at Kings College London have shown, fiscal policy should boost demand when interest rates are around zero. Now is not the time for governments to be good housekeepers.

And of course negative bond yields mean that governments are being paid to borrow. A 10-year yield of minus 0.38 per cent means that for every €100 (£92.83) the German government borrows it will repay only €96, and even less in real terms. Sometimes, though, people don’t respond to incentives.