Negative Rates on $1.5 Trillion of Debt Become Thing of the Past

Everyone knew it defied logic to pay for the privilege of lending trillions of dollars to European governments.

But two months ago, that didn’t stop investors from doing exactly that, causing the pool of European bonds with negative yields to soar to almost 3 trillion euros ($3.4 trillion) as of mid-April, Bank of America Corp. data show.

That trade is now dying quickly. The amount of such securities in the market has shrunk nearly in half, to 1.6 trillion euros as of June 9.

So, what happened? The European Central Bank didn’t back away from its plan to buy more than a trillion euros of debt nor did it lift its benchmark deposit rate above zero.

Instead, investors just seem to be returning to their senses (at least a little bit) as the euro-area shows signs of stabilizing. There are flashes of progress in Greece’s seemingly endless attempt to avert default. Oil prices have rebounded, helping boost the prospects of inflation in both Europe and the U.S.

All that has led to a dramatic surge in sovereign bond yields and a drop in the euro-region’s debt values. Yields on 10-year German bonds rose to 1 percent from as low as 0.05 percent on April 17 while yields on similarly-dated Swiss bonds rose to 0.3 percent from negative 0.3 percent on Jan. 23.

The $5.3 trillion Bank of America Merrill Lynch Euro Government Index has lost 6 percent since April 15, equal to about $300 billion of market value.

Extended Trade

Now what? Are negative yields headed for the history books, destined to be discussed in business classes as epitomizing the great era of central-bank experimentation?

“Certainly in hindsight, people are looking at the dip into negative yields as an over-extension of the trade,” said Ian Lyngen, a government bond strategist at CRT Capital Group LLC in Stamford, Connecticut. While negative yields may still exist among shorter-term bonds for a while longer, they’re unlikely to return among longer-dated securities anytime soon, he said.

The fate of negative-yielding bonds depends in large part on whether the data emerging from the European economy continues delivering positive surprises.

After all, the only reason it makes sense to buy this stuff is if a) yields are going more negative and prices ever higher as the economy weakens, b) if there’s a massive correction that causes huge losses in every other type of investment, or c) if the ECB expands its already unprecedented stimulus effort.

If recent history is a guide, the bonds that still have negative yields are pretty unstable. So, unless investors start worrying about deflation again, more of these securities may soon join their former peers as a thing of the past.