The vicious circle of negative rates

Thierry Million
Written by

23rd June 2016

This month, for the first time ever the yield to maturity on 10-year German bonds has fallen below zero. Buyers of these bonds do not seem to be concerned about their yields. In fact, investors that bring them into their portfolios are now seeking to protect their assets at any price, even if they have to pay for the privilege.

But what do these negative rates actually tell us? They merely prove that the crisis is far from over, seven years after peaking. In their determination to restore the normal financial channels of monetary policy transmission, central banks continue to flood the markets with liquidity, while placing a tax on holding that liquidity (e.g., via the ECB’s -0.40% deposit rate). They are inflating a bond bubble and squeezing yields throughout the curve, and thus sending investors into uncharted waters. This is a dangerous game, as bond market dynamics are such that, the further yields fall, even into negative territory, the greater the exposure to shifts in interest rates. The potential loss, in the event of an upturn in interest rates, has never been so great. Savers, who have already been deprived of yields, are now exposed to a downside risk that is 50% greater than in 2008.

What’s more, the flattening of the yield curve is counterproductive. It slows the expansion in bank lending, as the duration of exposure is no longer remunerated accordingly. This results in under-investment in parallel with heavy savings, which is keeping the equilibrium rate below zero.

Many have previously drawn comparisons between the Eurozone today and Japan in the 1990s, but it may be that ECB policy today is itself a contributory cause of the Japanification of the Eurozone economy, rather than acting as a solution to the Eurozone’s problems.

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