As you may have noticed, interest rates are very low at the moment. In fact, they may be the lowest they have ever been. As I write this piece in the middle of August, some $13.4 trillion in global government debt actually trades at negative yields, representing an astonishing 1/3 of all sovereign debt outstanding. A quick survey of the global bond universe reveals the following interest rates now offered on ten-year government bonds in developed countries:
Notice that the United States, at 1.57%, is the highest yielding market on the list. Switzerland, the lowest yielding country, currently offers no positive-yielding government debt at all – even on bonds with a 50-year maturity! It certainly is a great time to be a borrower. But what is really going on? And why would investors “pay” interest for the privilege of lending money to their government?
There are many factors at play here, but three stand out as the most culpable. The first is a powerful and persistent fear of deflation, an economic state where general price levels decline over time. In a strong deflationary environment, negative yields can make economic sense, because real, inflation-adjusted returns can still be positive even when the “nominal” (unadjusted) yield is negative.
For example, if the general price level in Japan declines by 1% annually for the next ten years, a government bondholder will receive a positive real return of 0.89% per year. And in fact, both Europe and Japan have experienced outright deflation in some recent periods.
Secondly, there are significant currency effects happening underneath the surface that are also having an influence on bond yields. Let’s look at Switzerland for example. While most European countries use the Euro as their currency, Switzerland has retained the Swiss Franc.
Over the last several years, the Swiss Franc has appreciated strongly against the Euro. Despite the negative yields on Swiss government bonds, investors from Euro countries who invested in Swiss Franc-denominated bonds have enjoyed positive returns after accounting for the gains in foreign exchange. As Swiss yields remain strongly negative today, the market is clearly stating that it expects the relative appreciation of the Swiss Franc to continue.
Finally, in what may be the most powerful force at work here, we cannot ignore the ongoing “unconventional” monetary policy response by the world’s central banks in the wake of the 2008 financial crisis and global recession. “Conventional” monetary policy, the only kind implemented outside of Japan until fairly recently, mainly involves altering the short-term rate that banks pay to borrow money either from the Federal Reserve or from each other.
However, during the post-financial crisis recession of 2008, the Federal Reserve lowered these short-term rates all the way to zero, but the economy continued to weaken and inflation remained well below their stated 2% target. It was then decided to pursue unconventional monetary policy in an attempt to further stimulate aggregate demand and offset the deflationary impact of simultaneous consumer and corporate deleveraging.
This new policy, dubbed “quantitative easing”, effectively created a large new supply of money, which the Federal Reserve then invested in US Treasury and Agency (mortgage) debt securities, raising their prices and lowering their yields, exactly as intended.
While the United States ended their QE policy in October of 2014, total central bank asset purchases have actually expanded since then, led by the Bank of Japan and the European Central Bank as shown in the following chart:
Some $180 billion is being invested into longer-term government debt by global central banks each month, and this is expected to continue at least into 2017. With such a powerful tailwind, there is no doubt that this is having the intended effect of lowering government bond yields around the world.
When will this all end? Unfortunately no one knows for sure. Market prognosticators calling for interest rates to rise have been continually proven wrong now for many years. But because none of the forces currently at work today are likely to be permanent, we can expect bond yields to move up eventually, and negative yielding debt will become an historical curiosity.