Going Negative?

Includes: SHY
by: Douglas Tengdin, CFA

Negative interest rates in Europe are pulling US rates lower.

Bonds are an option on currency appreciation.

Negative rates will lead to increased economic volatility.

What's up with negative interest rates?

Temperatures aren't the only thing below zero these days. Around the world bond yields have gone negative. It started a few years ago in the US, when ultra-short Treasury Bills would go negative right around quarter-end. That was understandable as a combination of the Fed's Zero Interest Rate Policy and institutions needing Treasuries for collateral on swap contracts. But a few months ago short rates in Europe went deeply negative-Denmark, Germany, and especially Switzerland. What's going on?

2-year Government Bond Yields as of 2/4/15 (in blue):

Source: Bloomberg

First, the basics: a negative yield means investors will lose money in the local currency if they purchase a bond and hold it to maturity. Why would anyone do this? The key is understanding investors' intentions. Bonds are denominated in a local currency. If that currency appreciates, investors gain relative to other currencies. The negative yields in euro-area bonds represent an option on that country leaving the euro - or, in the case of Switzerland and Denmark, abandoning a currency peg - before the bond matures.

Historical 2-year Government Bond Yields:

Source: Bloomberg

There's also the issue of what alternatives there are. When the European Central Bank announced it would start charging banks on their reserve balances, the banks started plowing money into short-term bonds. After all, -.1% for French OATs isn't so bad when your other choice is -.2% at the ECB. And banks have to hold reserves somewhere. By this reasoning, the central bank's negative rate is a natural floor for bond yields, apart from the currency option.

This has had an impact in the US. Over $3.6 trillion in global government bonds now pay a negative yield. Two-year US Treasury yields at 0.5% are a bargain compared to -.2% for German bunds. And with our economy doing better, there is potential for dollar appreciation.

The implications of negative bond yields are significant. If the risk-free rate is negative, there are immense incentives to borrow and invest. The return necessary for a project to be profitable is a lot lower. We should expect more leverage in the system and more volatility as marginal proposals get funded. After all, marginal projects tend to fail at a faster rate-that's why they're marginal. Negative rates also raise the risk of a significant disruption to the banking system.

This should end when growth resumes and central banks move rates back to normal. But there's no telling when that will be, especially with the threat of a breakup looming over the euro. For now, we're living in a Bizarro World where governments are paid to borrow and investors buy bonds that lose money.

I don't expect negative yields to last; negative yields are irrational in the long run. Still, it's dangerous to bet against them. Markets can remain irrational longer than investors can stay solvent.

Disclosure: The author has no positions in any stocks mentioned, but may initiate a long position in VARIOUS STOCKS, BONDS, AND CURRENCIES over the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The author is Chief Investment Officer of a $1.6 trillion trust company. The company holds long positions in a broad variety of stocks, bonds, mutual funds, and ETFs.