Wednesday marked the day when the President of the United States personified that age old warning handed down to every child from every parent: if Hugo told you to jump off a bridge, would you do it?
President Trump took to Twitter to call the Federal Reserve a bunch of “boneheads” all the while asking for them to do what the European Central Bank is doing: give banks free money, and a bonus on top of it for taking out a loan. It’s called negative interest rates. And it’s a total savings destroyer, one that has obviously done nothing to improve the European economy, or its stock market which has not recovered despite free money designed, in part, to go into equities.
The European Central Bank is expected to announce a negative benchmark rate after its next policy meeting on Thursday. Some $17 trillion worth of bonds in Europe pay zero interest or negative interest.
Since the Great Financial Crisis, quantitative easing and low interest rates have made the task of quantifying risk more of a political question, rather than something the market would decipher at an analysts desk.
In Europe, the central bank became the buyer of generally unloved assets. Buy a junk bond in the market for 100, sell it to the central bank for 101, guaranteed. Then do it again.
Selling to the central bank pushed yield down so low that it turns fixed income instruments into a stock. Investors aren’t buying for the yield. They are only buying because they are required to, at great risk to the enterprise itself, or because they are looking for a capital gain – like a rising share price. A negative half a percent bond is worth more than negative one percent bond, and so on.
A fixed income product like a government bond, or a savings account, that pays no income, should be the very definition of a toxic asset. Instead, it’s an actual product that investors buy. German bond yields are -0.56%.
What is the risk premia when investing in sovereign debt markets? The answer can no longer be reliably found in bond prices, yields, budget numbers, inflation or GDP growth. Even prices of credit default swaps are meaningless. (As an aside, this is a potential death knell to bond traders, already being priced out by technology. This has to make it even worse.)
For example, the price of a 5-year credit default swaps on Italian sovereign debt is 140.3 basis points over Treasurys. In normal times, if the 5-year Treasury yield was 1%, then that CDS price would assume Italian risk puts its equivalent bond price at 140 basis points higher, or 2.4%.
Instead, the Italian 5-year government bond yield is 0.33%. And the U.S. 5-year is 1.58%, the total opposite. This disparity is all because the ECB has committed itself to negative rates and the markets must follow.
It’s The Opposite.
“If every instinct you have is wrong, then the opposite would have to be right.” – Jerry Seinfeld to George Constanza.
Negative rates are just another financial product, then. Or are becoming one. This is what ECB’s new president Christine Lagarde will say. If it is negative 10 or negative 110, so what? If people want to buy it like they are buying a put option on Ford Motor Company stock, then the market will name its price. It’s not like you can buy groceries with that option contract. But if you sell it at a gain, you can! The same can be said for negative debt. It’s like the market’s new pet rock. If you assign value to the pet rock, even if you found it on the street for free and just painted a smiley face on it with colorful permanent markers, and someone pays for it, then that’s a profitable transaction regardless of the rock’s usefulness.
Like George Costanza in that Seinfeld episode where he comes to the realization that every decision he makes is the wrong one, investors have to go against their instincts. This is the entire concept of negative yielding debt. It’s the opposite of everything you ever imagined a bond to be.
Italy has higher unemployment, an economy in recession, and a rising budget deficit.
The new government has increased their deficit target to 2.4% of GDP for 2020. They also have a less pro-growth government.
Despite a much weaker outlook, their bonds are priced as if they are the hottest market around with near zero risk. Everyone wants to lend to Italy. They are so desperate to do so, that they’ll take around 0.97% on a 10-year Italian euro bond.
The U.S. 10 year pays 1.75% and its economy is in much better shape. Only a negative interest rate policy would allow for such a higher risk and a lower reward, as is the case in Europe.
Yet, someone is buying this stuff.
“We consider it a fair point for Trump to pine for lower rates, but we disagree that there is anything positive about negative rates,” says Vladimir Signorelli, head of Bretton Woods Research, a big picture investment research firm out of Long Valley, New Jersey.
Back in 2016, Deutsche Bank’s CEO at the time, Jon Cryan, warned that negative yielding bonds could have “fatal consequences”. He said: ” Monetary policy is now running counter to the aims of strengthening the economy and making the European banking system safer.”
Last week, current Deutsche Bank CEO, Christian Sewing, warned of “grave side effects” for the region if the ECB delivered more monetary easing, noting that “in the long run, negative rates ruin the financial system.”
Well, guess what’s coming to Europe? This is a guarantee now.
Either the European bankers get used to negative rates and treat it as their pet rock to which they will assign value and trade it among themselves, meaning the Lagarde (and in a way, Trump) is right, or the European banking system collapses. Entire trading desks are shuddered. The European bond trader gets put on the endangered species list.
Does Trump really want that to haunt the U.S. financial services sector? A cynic might say: if it guarantees the S&P 500 another 20%, like it did the MSCI Europe since 2016, then maybe he does.
However, every American savings account and money market fund, barely paying interest as it is, would be a money loser.
Try selling a negative yielding bond fund as a private wealth manager to a client.
UBS CEO Sergio Ermotti recently underscored how negative rates were leading to “absurd situations” in Europe. Banks are being discouraged from holding deposits. Savings accounts, as a traditional bank product, are going the way of the dinosaur.
Trump’s potential nominee to the Fed board, Christopher Waller, once said negative interest rates were a “tax in sheep’s clothing.” It’s a punishment for not investing in the stock market.
Retail investors and most companies, large and small, are not going to go to a bank and be given a negative interest rate loan.
BNP Paribas economists said this week that they do not expect negative rates in the U.S.
“We think the 10 year touches 1%,” says Shahid Ladha, head of strategy for G10 rates at BNP. “But next year at some point it will go back up to 1.5%.”
The market is pricing in four rate cuts. If each one is 25 basis points that would bring the Federal Funds rate to as low as 1%.