Investment
Negative interest rates
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In 1987, the then Federal Treasurer Paul Keating remarked that if you went into your local pet store, you would find the galah talking about microeconomic reform. In 2019, those same galahs (they can live up to 40 years) must surely be talking about negative interest rates.

There are currently US$16.4 trillion of securities with a negative yield1, accounting for around one-third of the global tradeable bond universe. This includes German government bonds with a maturity of 30 years, and even some European 'high yield' bonds.

Figure 1. Switzerland, the Eurozone, Denmark, Sweden and Japan all have negative yielding government bonds
Source: Bloomberg as at 3 September 2019.

So far Australia has avoided negative interest rates (in nominal terms, ie. not adjusting for inflation). However, with the Reserve Bank of Australia having recently reduced interest rates twice, and with interest rate markets pricing the possibility of two further cuts by the end of the year, it may be timely to ask whether or not we are likely to see investors having to pay to store their cash in Australia.

Why would anyone buy negative yielding securities?

People have a hard time getting their head around negative interest rates. Why would someone voluntarily part with their money for a period of time, potentially many years, only to end up with less of it? This seems especially odd when the investment is far from risk free. Interest rates could rise, which would reduce the value of long dated bonds. Furthermore, in the case of riskier debt, there could be a credit event or possibly even a default. Surely this is a bubble waiting to burst?

That could well be true, but it turns out that it might not be quite so simple. When you factor in central bank asset purchases, and the 'cross currency basis' that results from asymmetric global capital flows, negative interest rates might be more sustainable than many people realise.

Central bank asset purchases

Central banks are mandated to implement policies that result in price stability and economic development. In recent years they have done this by setting central bank deposit rates very low, and by buying longer dated bonds to push yields even lower, in the hope of incentivising borrowing and spending. The Swiss National Bank, European Central Bank, Sveriges Riksbank (Sweden) and the Bank of Japan (BOJ) have all utilised large bond purchase programs, otherwise known as quantitative easing (QE).2 Central banks are often price agnostic when implementing QE-they just keep buying regardless of price-hence there is no reason why the yield to maturity of a country's debt securities cannot go negative.

Why do central banks want to drive rates below zero? In short, to prevent deflation and stimulate their flagging economies. Take Japan, which accounts for over 40% of all negative yielding debt securities globally, as an example. Over the past 10 years, consumer price inflation has been below the BOJ's 2% price stability target 90% of the time, and below zero (deflation) 35% of the time.3 The BOJ has maintained an asset purchase program since 2010, in the hope of generating inflation.

Whether or not quantitative easing is effective at creating inflation is still subject to much debate, but it is nevertheless one of the key drivers of negative interest rates. It also has the effect of providing private investors with a safety net, often described as the 'central bank put'. Yields can only rise so much while the central bank is buying bonds. Investors stand in the way of central banks at their peril.

  1. Bloomberg, August 2019.
  2. The Denmarks Nationalbank technically doesn't undertake QE, but because the Danish Krone is pegged the Euro, it somewhat adopts Eurozone monetary policy.
  3. Bloomberg, Japan CPI Nationwide YoY Index as of 3 September 2019.

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