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.