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June 13, 2016

What's Driving the Madness of Negative Rates in the Bond Market?

By George Yacik, INO.com

With interest rates on 10-year Japanese government bonds already deep into negative territory and comparable German bunds just a basis point or two away, most of the world’s safest debt instruments are trading below zero. With the notable exception of U.S. Treasuries.

While we’re still a long way from reaching that point – the benchmark 10-year Treasury note ended last week at 1.64%, its lowest level in nearly a year-and-a-half and down more than 60 basis points so far this year – it’s certainly not too early to start thinking about it. After all, if it can happen in Germany and Japan and several other countries, why not here?

Switzerland’s 10-year government bond closed last week at negative 0.50%, while the comparable Japanese bond ended at minus 0.15%.

Germany’s 10-year bund, the benchmark for the euro zone, closed at just two basis points above zero. The average yield on all German government debt outstanding is now below zero.

In real life, this means that if you buy a Swiss or Japanese bond today and hold it to maturity, you’re guaranteed to lose money. Such a deal.

What’s driving this madness?

Nervous investors have fled to the safety of sovereign bonds in the face of a weakening global economy and concerns about the U.K.’s possible exit from the European Union, plus the U.S. election, too, no doubt.

Last week the World Bank cut its global growth forecast for this year by a half a percentage point, mainly due to a sharp downward revision in the outlook for advanced economies, led by the U.S. The bank now expects world GDP to grow by only 2.4% this year, down from 2.9% in its January forecast. A good part of the lowered forecast was due to the U.S., where the growth outlook was slashed to 1.9% from 2.7%.

But a lower growth forecast is hardly the main reason for the sharp drop in bond yields. The main reason is the bond bubble created by the world’s major central banks, which are grossly distorting bond prices and yields by buying up more and more debt for no seemingly good reason other than to keep driving rates lower and lower in the hope that something good will eventually happen.

The latest blast of air was provided last week by the European Central Bank, which started buying nonbank corporate bonds for the first time. The bank has been buying sovereign government debt for several years, then began buying bonds issued by commercial banks. Since none of that has done anything to raise inflation, it’s now trying its luck with bonds from industrial companies, utilities and the like.

Needless to say, this is rendering meaningless the historic connection between credit worthiness and interest rates. If the ECB is buying up everything in sight, everything will have the same value, no matter how sound the underlying company’s financial condition. It can also lead us down the slippery slope of central banks buying the bonds of companies they like for political reasons and ignoring ones they don’t. Is that the way we want the global business economy to work?

It’s also encouraging companies to take on more and more debt to take advantage of these historically low interest rates, whether they put it to productive use or not.

The ostensible goal of all this bond buying is to boost economic activity, but that clearly hasn’t happened. Many companies, it seems, would rather buy a Swiss bond with a built-in loss or pay to keep their money on deposit in a European bank rather than risk it by investing it in their own businesses.

For years, we’ve heard that the Fed and other central banks are fighting against the dangers of deflation. Yet, it seems that that’s exactly the situation they’re creating.

One business that seems to be thriving as a result of all this central bank intervention is the safe business – you know, those big heavy things you keep money and valuables in that for some reason always find themselves landing on Wile E. Coyote?

Japanese safe companies can’t keep up with demand from people buying safes to keep their money in just in case banks starting charging them to hold their money, as they do for corporations. That hasn’t happened yet, but who’s to say it won’t someday – and soon? Why take the chance?

This is what we have to show for a near decade of central bank intervention in Western economies—people hiding their money in safes and mattresses.

The Federal Reserve can strike a blow for sanity this week by raising interest rates at its monetary policy meeting. Alas, that’s not likely to happen.

Janet Yellen pretty much put the kibosh on that last week when she quite deliberately left out the words “in the coming months” in a speech in Philadelphia. While she said she believes “the federal funds rate will probably need to rise gradually over time,” she wasn’t more specific about when that might happen like she was just two weeks earlier.

Market prognosticators aren’t giving much of a chance of rate rise at the July meeting, either, and as I said in this space last week, I don’t think September is going to happen either because it’s too close to Election Day.

Bill Gross warned last week that the “supernova” of $10 trillion in negative-rate bonds “will explode one day.” That day seems to be getting uncomfortably closer by the minute.

Courtesy of George Yacik , INO.com

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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