Negative Rates Forever

The ECB seeks to set short term interest rates in the Euro Area via control over the amount of liquidity it supplies to the banking system, as the latter is required to observe a minimum reserve requirement, in turn related to the amount of customer deposits each bank holds. The current requirement is around €140bn in aggregate and currently banks have €3,000bn deposited with the ECB, implying excess liquidity of some €2,900bn. This will generally put downward presure on money market rates but there is a floor, in theory at least, which is the ECB’s Deposit rate, which has been in negative territory for over six years now . It was cut to -0.5% last September and if money market rates fell below that banks could borrow in the market and deposit back to the ECB at -0.5%, so this potential arbitrage will generally keep rates above the Deposit rate.

The scale of excess liquidity is such that rates are very close to that floor, nonetheless, with 3 -month euribor trading at -0.486% in recent days. Indeed one money market reference rate, the euro short term rate or €STR, is trading below the Deposit rate ( at -0.54%) because it includes non-bank borrowers, unlike the conventional euribor rates.

How long will these rates last? That ultimately depends on the ECB’s perception of the inflation outlook, but judging by expectations in the money market it will be years before we see a return to positive short term rates- the market is currently pricing in a 3 month rate of -0.125% in six years time. That may not transpire of course but as it stands it implies that rates are expected to be in negative territory for well over a decade, and not the short time period envisaged by the ECB when when embarking on that policy.

Does it matter? The standard ECB argument is that negative rates are just an extension of low rates and will eventually boost credit growth, economic activity and inflation. However, negative rates have put pressure on EA bank profitability in that they have indeed helped push down borrowing costs for households and businesses but , to date, at least, most banks have been reluctant to cut deposit rates for households by a similar amount, which would take them below zero. The ECB argues that this hit to bank margins can be offset by loan growth but negative rates send a signal to potential borrowers , implying a pretty dismal economic outlook and one not conducive to productive investment spending by the private sector. Of course if one also factors in the impact of the Covid pandemic it is difficult to see an explosion in credit growth any time soon.Not surprising , then, that EA banks trade well below their equivalents in the US in terms of equity valuation, with Irish banks at around 20% of their net asset value.

There are other issues, which will become increasinly pressing if negative rates are here for the long term. The ECB can provide liquidity but can’t direct where that goes and it may simply be used to bid up existing assets such as equities and real estate. Negative rates are also a massive challenge to the long established investment model of pension funds and wealth managers. That model envisaged say a 60-40 split betwen equities ( deemed higher risk) and bonds and cash but what happens to that model when the yield on the lower risk asset is actually negative ( as is the case with many EA government bonds) and where large deposits with a bank can be charged a negative rate. In other words a fund will lose money by holding cash in a bank or by lending it to the Government. This leads to the TINA (There Is No Alternative) case for taking more investment risk so pushing up equity valuations, real estate prices and lowering the yield on high risk corporate debt.

It is hard to see how the ECB can get out of the current situation, although it does seem reluctant to cut the deposit rate again, and the implicaions of negative rates for savers are not palatable. Commercial banks may well start to cut deposit rates into negative territory for household deposits with significant implications for high savings economies such as Ireland, where household deposits and currency exceeds debt by €21bn, and where deposits in Irish headquartered banks are €37bn higher than loans. The cost of borrowing for households is low, of course, and in Ireland that mainly flows into property but that is constrained by mortgage controls, which do not apply to institutional investors..

Negative repo rate at the ECB?

Economic growth in the euro area (EA) has been trundling along at 0.4% per quarter, which is probably above the zone’s potential rate but has not been strong enough to put much upward pressure on prices; core inflation is likely to average under 1% in 2015 and although some acceleration is generally expected  over the next few years it is forecast to be modest. The ECB’s inflation target is set in terms of headline inflation, which is currently lower still, at around zero, and again that is expected to pick up, reflecting the unwinding of the recent falls in commodity prices, but few if any forecast a rebound to 2% or above  by end-2017.

Low or zero inflation is supportive of real household incomes given the modest pace of wage growth ( 1.9% in the EA in q2  and 1.8% in Ireland) but the ECB is concerned about a prolonged period of below-target inflation, not least in terms of its own credibility. A more fundamental reason is that the real rate of interest (the nominal rate minus expected inflation) rises if expected  inflation falls, which all else equal will dampen investment spending in the economy.

Those concerns have prompted the Governing Council to contemplate further monetary easing, including additional non-standard measures such as an expansion of QE. The latter has  helped to boost asset prices in the EA and lowered corporate and bond yields, according to the ECB,  but it is less clear what impact that has on inflation- the effect on demand in the economy may not be large enough to put significant upward pressure on prices. QE is also deemed to weaken the currency and the euro certainly fell sharply in the early months of 2015, declining by 11% in effective terms to mid-April. According to   the ECB’s models, a 5% depreciation could boost inflation by up  to 0.5 percentage points so a currency depreciation would  seem to have the biggest impact on prices.

The euro reversed course over the summer months, however, rising by  7% in the four months to end-August , but has started to fall again and is currently about 7% below its value a year ago, albeit still 2.5% above its April lows. This also reflects  the expectation of rising rates in the US but the ECB may well seek to precipitate a much steeper fall in the effective exchange rate.

To that end the ECB has flagged a possible  cut in its Deposit rate, which for over a year has been at -0.2%. Despite that, deposits at the ECB, which had been very low at the beginning of the year, have risen strongly of late and currently stand at €187bn i.e. banks  would prefer to pay to leave cash at the ECB rather than lend it to their peers. Draghi had previously indicated that rates had reached the effective lower bound but that may be reassessed, not least because the deposit rate is at -0.75% in Switzerland and Sweden. Consequently, any  Deposit rate cut in early December may be larger than the modest change generally expected and a rate of -0.5% could be on the cards, which would also increase the universe of bonds eligible for QE.  Similarly, the refinancing rate could also move to zero or even marginally negative (the Swedish reo rate is -0.35%) if the ECB wants to surprise the markets and engineer a more substantial fall in the exchange rate.

 

Why buy Bonds with negative yields ?

Negative bond yields are no longer a rarity across the Euro area,  accounting  for over half the government debt at issue in some countries (Germany, the Netherlands and Finland) and well over a third in others (Austria, France and Belgium).  Moreover, what was generally confined to shorter term debt is now extending along the yield curve, and  many now expect German 10-year yields  (currently 0.15%) to  follow Switzerland into negative territory.

Low bond yields are one thing but negative yields are a rare if not unique phenomenon. The former may be generated by a flight to quality but if widespread imply that investors expect short term interest rates to stay low for a long time. That in turn signals an expectation of limp growth and little or no inflation for a prolonged period.  Nonetheless, very low yields still mean a positive return, albeit a limited one: if I buy the German 10-year benchmark, which pays a coupon of 0.5% per annum, I will receive €5 per €100 invested in interest , offset by the capital loss on the bond ( it is trading at  €103.35). This will reduce my total return over 10 years to just €1.65.

That level of nominal yield is obviously  very problematical for savers or for the pension funds that are investing the savings of companies or households. That meagre return is also nominal, of course, and would mean a substantial loss in real terms even with very low inflation over the period.

Nonetheless,  any holder to maturity will not face a nominal loss, in contrast to that  awaiting  an investor with the same time horizon  buying a bond at a negative yield . Take the  2%  Jan 2022 Bund, which is priced at €113.80. Over  the 6.7 years  to maturity the interest will amount to €13.40 but this will be offset by the capital loss of €13.80, ensuring a negative nominal return.

Why  would anyone buy a bond which gives a loss if held to maturity? Some argue that investors are now  simply buying on the expectation that someone else will buy it at a higher price, a classic bubble, but there are other explanations. In the Swiss case investors may believe that the currency will appreciate  significantly, so ensuring a positive return for a non-Swiss  buyer. One doubts if many expect the euro to  outperform most of the other major currencies, however, so other factors are at work. One is QE, in that the ECB is a buyer in the market at any yield above -0.2%. The ECB will not buy all the bonds at issue, however,( the limit is 33% , at least for now)  so  investors  will still be left holding two-thirds of the market.

A second rationale relates to banks, the main buyers of shorter-dated bonds.  For them, any excess liquidity deposited with the ECB costs them 0.2% so any yield above that, even if negative, is viewed as a plus. The implication is that banks would also prefer to park liquidity in bonds, however low the yield, than lend it to firms or households – such lending requires higher capital backing and in general carries  a higher perceived risk. One should also remember that banks are also now required to hold a specified amount of assets in liquid form, as part of the Basel 111 regulatory changes, which  in effect means a greater demand for government bonds at the same time as the ECB has entered the market as a buyer.

For investors as a whole the low or even negative return on bonds is supposed to act as an incentive to switch to other assets, including equities and corporate debt, although again, regulatory constraints for pension funds and insurance companies may make a significant switch into riskier assets problematical.

In the short term, then, a combination of QE and pessimism on growth and inflation has led to a collapse in the risk free rate of return, with the possibility of 10-year yields and beyond turning negative. That has serious practical implications for savers and those relying on annuities in retirement. At another level, it throws up difficulties for asset valuation models, as the risk free alternative is now a negative number. How all this ends is anyone’s guess but there is a paradox at its heart; if QE stimulates growth and leads to a rise in inflation over the medium term, perhaps due to a much weaker currency, it makes negative bond  returns in real terms all the more likely for anyone buying to hold at these levels.