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The ECB is taking steps to depress interest rates. Some time ago it imposed a negative rate on deposits placed with it by banks, and it has now embarked on a big QE programme. The widespread negativity in Europe is largely a response to this: yields have been falling on all euro area sovereign debt except those of Greece ever since QE was announced, and the “safest” bonds are now yielding negative far along the curve.
But this should be seen in the context of negative inflation. A deposit rate of minus 20 basis points when inflation is minus 0.2 per cent is no loss; It simply maintains the real value of the deposit. Similarly, nominal interest rates between zero and minus 0.2 per cent on commercial lending are positive real rates. It is hard for people to get their heads round the idea that a negative nominal rate can be a positive real rate — but that is the situation. So Germany’s recent five-year bond issue at minus 8 bps was not what it seemed. With present inflation expectations, the real yield on that bond is positive.
The ECB says it will not buy bonds yielding less than minus 0.2 per cent. If it was hoping that this would set a floor on yields, it is doomed to disappointment. Market participants can trade with each other at far lower yields than the ECB’s limit. As the ECB removes bonds from circulation, they will become scarcer, forcing prices up and yields down. There is clearly an opportunity for money to be made on bond price appreciation.
And therein lies the problem with what is commonly known as the “zero lower bound”. The belief is that rates cannot go significantly below zero because people will switch into zero-yielding risk-free assets, principally but not exclusively physical cash. In the last few years, monetary policy has been to a considerable degree hamstrung by this belief. But there is growing evidence that it is a myth:
First, the zero lower bound is not zero but slightly negative. It is not clear exactly how negative it is, but holding physical assets is not cost-free: for physical cash and gold there are vaulting charges, and there are storage charges for other assets such as metals.
Second — and far more importantly — the zero lower bound theory implicitly assumes that most money is kept in the form of non-tradeable instruments such as bank deposits. A bank deposit yields only its face value, so a minus 20 bps interest rate is erosion of its nominal value. But most money is not kept in this form. Most of it is held as tradeable instruments, and the yield on those reflects their price. Traditionally, bonds have traded at a discount to their face value: but if a bond is yielding negative, it is trading at a premium to its face value. This affects investor choices, of course, but it does not in any way imply that they would opt for zero-yielding assets instead.
For investors, the yield at the point of purchase does not matter: it is the future path of yields that matters. And this is determined largely by inflation expectations and the behaviour of central banks. If the expectation is first that inflation will continue to fall and second that central banks will continue to intervene in markets to try to prevent inflation falling, then yields will continue to fall without limit. In bond markets at present, the “zero lower bound” does not exist.
There are a couple of interesting points arising from this. First, the investment function of government bonds is changing. Traditionally, they have been used as hedges in a diversified portfolio. But once yields are deeply negative and falling, they can no longer be regarded as hedges: since holding them incurs an inevitable loss, they must be regarded as risky, not risk-free, and therefore actively traded for a capital return. Their replacement would, of course, be physical cash and other zero-yielding assets, possibly including zero-coupon issues from blue-chip companies.
Second, there are some unpleasant implications for banks. Although the zero lower bound is not binding in bond markets, it still is for banks. Even in a deflationary environment, retail customers — who provide the majority of banks’ stable funding — are generally unwilling to accept negative rates on deposits, especially as physical cash is an alternative. This, of course, is the reason for the ECB’s minus 0.2 per cent limit. It cannot lower the interest rate on excess reserves much without hitting the “slightly negative lower bound” at which banks would exchange reserves for vaulted cash.
But frankly, the possibility of banks converting QE-generated excess reserves into physical cash should be the least of the ECB’s worries. The current policy mix is deadly for banks. QE imposes on the banking system additional reserves that it does not need, while the ECB’s negative rate taxes banks for holding those additional reserves. Additionally, flattening yield curves make maturity transformation — the principal business of banks — unprofitable.
Full article on Financial Times (subscription required)