Rip Van Winkle's Bond Nightmare
Imagine yourself as Rip Van Bondtrader, waking after a decade of slumber, and eager to make some money in the markets. Surveying today's backdrop, you'd probably conclude that the euro experiment is a failure. You'd be astonished that the Federal Reserve's target interest rate has been at 0.25 percent for the past six years. And you'd be flabbergasted to discover that your peers were buying, selling and investing in government bonds that trade at negative yields. In short, you'd want to pull the duvet back over your head, and go back to sleep.
When you went to sleep ten years ago, the 10-year U.S. Treasury yield was about 4.4 percent, while Germany's equivalent borrowing cost was 3.8 percent. U.S. inflation was running at 3 percent and the economy was about to post growth of 3.6 percent; consumer prices in the euro zone were accelerating by about 2 percent, with the economy poised to expand by 1.4 percent.
Fast forward to today's economic environment. Annual growth in the U.S. was 2.4 percent in 2014's fourth quarter, while consumer prices contracted by 0.1 percent in January. The euro region is growing at an annual pace of about 0.9 percent, while figures today show prices declined by 0.3 percent last month.
It's the bond market, though, that's likely to give Rip nightmares. Government yields are suggesting a yawning bifurcation between a resurgent U.S. economy -- January's dip in consumer prices notwithstanding -- and persistent stagnation in the euro zone:
The yield gap between Germany (which pays about 0.3 percent to borrow for a decade) and Uncle Sam (at 2 percent) is at its widest since the end of the 1980s. Meanwhile, according to the debt market, Portugal is more creditworthy than the U.S., based on what investors charge each country to borrow for 10 years. So are Spain, Italy, Sweden, the Netherlands, and every other European Union member barring Greece. The higher yields available in Treasuries might tempt Rip, but the U.S.'s better economic outlook -- and the inflation that would likely come with it -- would be a strong deterrent.
It's the shorter-dated end of the bond market that Rip Van Bondtrader will really struggle to get his sleepy head around. An incredible $1.9 trillion of fixed income securities in the euro region have negative yields. Here's a selection of countries where investors are paying for the privilege of lending to the government for five years:
In theory, negative returns should prompt money to flow into the economy as savers choose to spend rather than pay to save, and banks opt to earn interest by lending cash to companies to invest rather than being charged for keeping deposits at the central bank. But, as economist Nouriel Roubini wrote last week, negative rates alone aren't enough to achieve higher economic growth:
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.
Moreover, as so often in recent years, the theory may be wrong about what happens when central bank rates are at or below zero. Some soothsayers, including legendary investor Bill Gross at Janus Capital, are starting to worry that these unprecedented conditions may actually hinder rather than resuscitate growth. In particular, Gross points out that matching long-dated liabilities, such as the obligation to pay pensions or pay your toddler's future university fees, by buying long-dated bonds becomes impossible when yields fall below zero:
What German, Dutch, or French insurance company would attempt to immunize liabilities at the zero bound or lower? Immunization makes no economic or business sense at these levels; similarly for pension funds. In fact even households are handcuffed by low/negative yields, who everyday must now address their inability to save enough money at a high enough rate to pay for education, healthcare, and retirement obligations. Negative/zero bound interest rates may exacerbate, instead of stimulate, low growth rates in all of these instances, by raising savings and deferring consumption.
Rip Van Bondtrader, plumping his pillow in 2005 as he laid him down to sleep, wouldn't have envisaged bond yields with minus signs. As Gross points out, negative interest rates were "rarely if ever contemplated" prior to 2014.
So here's a thought experiment. Suppose euro growth surprises on the upside as labor market reforms do their thing. Suppose it turns out that deflation has been repelled -- January's 0.3 percent decline in consumer prices was better than the 0.4 percent drop anticipated by economists, and accompanied by a 0.6 percent increase in core inflation, excluding energy and food prices. How nasty might the whiplash be in those negative-yielding bonds if the economic future turns out to be brighter than the unremittingly gloomy outlook that's currently reflected in bond values?
As Warren Buffett famously said, it's only when the tide goes out that you find out who's been swimming naked. Now might be a good time to check your Speedos -- before you find yourself inadvertently skinny-dipping in the fixed-income market.
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