Central Bank Induced Market Distortion Goes Bananas

“Conjuring Profits From Sub-Zero Yields”

 The above is the title of the recent Bloomberg article that discusses the ECB’s penalty rate on bank excess reserves (which as one analyst recently remarked have become the proverbial “hot potato” now that a 20 bp fine is charged for their possession) and its effects on bond markets. In euro-land, government bond yields have already completely collapsed, partly to almost Japan-like levels – and yet, more capital gains can still be achieved, even with paper sporting negative yields. According to the article:

“David Tan got to help oversee $1.5 trillion at JPMorgan Asset Management by picking winning trades. Now he’s studying how to make money from investments that look sure to lose.

Across much of Europe in the past year, the yield on two-year government debt tumbled from little, to none, and then below zero. That means buyers would walk away with less cash when the securities matured — if they waited that long.

Money managers like Tan are navigating a market where positive returns are still possible on debt with negative yields provided others will pay a higher price before the notes come due. Those opportunities were enhanced last week when the European Central Bank increased the cost for financial institutions to park their money with it. After that, depositors were tempted to take their cash from the ECB and funnel it intogovernment bonds, because the negative yields hurt less than the central bank’s more punitive charge.

“If yields continue deeper and deeper into negative territory, the opportunities for capital gains remain,” Tan, who is head of rates in London for the fund-management unit of the U.S.’s biggest bank. “If your central hypothesis is that yields are going to converge” with the ECB’s charge on deposits then you still see “some potential price appreciation,” he said.

The list of institutions that may choose to lose includes asset managers so large they’re willing to pay for their cash to be held safely as well as banks that want to avoid the higher ECB charges. And it includes many large financial groups like insurers whose rules are too inflexible to give many alternatives. At the top of the heap probably are other central banks.

Central bankers “are a fairly value-insensitive bunch,” Michael Riddell, a London-based fund manager at M&G Group Plc, which oversees the equivalent of about $415 billion, said on Sept. 5.“They have to invest their FX reserves somewhere if they want to buy euro-area assets that have the top credit ratings, then they have no choice.”