The Madness of Negative Bond Yields
As we have frequently discussed in these pages, time preference must always be positive on a society-wide basis – it is a praxeological law that future goods and/or satisfactions are valued at a discount to identical present goods. We emphasize “identical†here because sometimes people are asserting that there are exceptions, such as in the famous example that men would prefer having ice in the summer over having it in the winter (thus, in wintertime, ice available in the future would be valued more highly). However, “summer ice†is not identical to “winter iceâ€, even though it has the same physical properties. The reason is that the satisfaction if provides is not the same.
As an aside, this also explains why the assertion that the prices of goods will tend to equalize across the entire market economy (excl. transportation and other extraneous costs) is not disproved by the fact that a cup of coffee in Hicksville can be bought at a lower price than e.g. an identical cup of coffee offered by the Sacher coffee house next to the opera house of Vienna. In spite of the physical properties of the two cups of coffee being the same, they are not the same good. In the latter case one pays a premium for the view of the opera house and the general atmosphere of the location.
Germany’s two year note has a current yield to maturity minus 27 basis points. The centrally planned monetary system is careening out of control and producing unprecedented distortions in financial markets – click to enlarge.
As a result of this, the so-called natural interest rate can never be negative, but the same can obviously not be said of gross market interest rates. As a reminder, the latter include a price premium (which reflects inflation expectations) and a risk premium (which reflects an assessment of the borrower’s creditworthiness). So what can be said about the negative yields to maturity currently prevailing on many European government bonds?
Most importantly, it should be clear that such negative gross market rates would not come into being in an unhampered free market. Central bank intervention in bond markets is an important driver, as the ECB is e.g. prepared to purchase sovereign bonds up to a negative yield of minus 20 basis points. Another non-market driver are EU regulations concerning bank capital and the risk weighting of assets: government bonds have a risk weighting of zero (i.e., they are considered “risk freeâ€, which is of course an utterly absurd legal fiction), so banks have a strong incentive to hold these bonds irrespective of their yields. Also, banks need to hold “high quality†collateral for repo transactions, and they pay a 20 basis point penalty reserves held on deposit with the ECB. All these technicalities play into the decision to hold government bonds with negative yields.
However, one could well argue that a negative price premium is in the realm of the possible. If a bond maturing in two years time yields a negative 20 basis points and investors expect future “price inflation†to clock in at a negative 50 basis points, they are still making a profit of 30 basis points in real terms if they hold the bond to maturity. It would of course be even better to simply hold cash currency: the real gain would be 50 basis points, and the financial risk incurred would actually be slightly lower. However, if one needs to invest 100ds of millions, holding such a vast amount of physical cash requires vaulting services and involves insurance costs, while enacting transfers and payments becomes relatively complicated. Many large investors therefore see negative yields on bonds in as a fee they incur for the convenience of holding bonds rather than large amounts of cash currency.
However, another very important driver of negative government bond yields in Europe is undoubtedly distrust of the banking system, combined with the realization that the era of tax-payer bail-outs of banks is drawing to a close. From January 2016 onward, the EU’s Bank Recovery and Resolution Directive will become law all over the EU. Every large depositor and unsecured creditor to European banks must thereafter expect to be “Cyprused†if a bank gets into serious trouble.
