The U.K. government achieved a dubious milestone on Wednesday, May 20. It sold its first ever batch of negative-yield bonds.
In 2016 — when Brexit took markets by surprise — a one-month U.K. treasury bill went negative. But May 20 was Britain’s first time for a conventional longer-term bond.
The offering was for 3.8 billion pounds worth of three-year gilts (debt securities issued by the British government). The auction was more than twice oversubscribed, with 8.1 billion pounds worth of submitted orders, at a yield of negative 0.003%.
We explained how negative yields work in “The Mechanics of Negative Interest Rates.”
To quickly recap, yield is a function of the bond price. If the price paid is high enough, the yield goes negative, which means the buyer loses money if they hold the bond to maturity.
So why would buyers purchase three-year U.K. gilts at a negative yield? For three possible reasons.
One reason is speculative. If the yield goes even more negative, which means the bond price goes higher, the early negative-yield buyers might expect to make money on the trade.
You are only guaranteed to lose money on a negative-yield bond if you hold it to maturity. If you sell the bond prior to maturity (i.e. trade it) at a higher price than you paid — that is to say, at an even more negative yield — you can make a profit. Rather than “buy low and sell high,” this is a game of “buy high and sell higher.”
So, buyers of three-year gilts at a slightly negative yield might be anticipating even more negative yields, by way of higher gilt prices, in the near future.
This could happen because the Bank of England (BOE) has embarked on a “quantitative easing” (QE) program to help fund record levels of borrowing from the UK government as a result of the pandemic. If the BOE is a steady buyer of gilts, yields could go even more negative.
Another potential reason is fear of outright deflation.
Institutional buyers will sometimes buy sovereign bonds, at almost any price, for a lack of preferable alternatives. If the British economy is staring deflation in the face, as the result of its worst economic crisis in 300-plus years, gilts that lose a tiny smidge of capital (via negative return) could outshine other UK assets at risk of losing a lot.
A third possible reason is anticipation of the BOE “going negative” on purpose.
If this happened, the BOE would announce negative rates as a function of official policy, and deliberately target a below-zero yield at the short end of the curve. (The current UK “base rate,” comparable to the U.S. Fed Funds rate, is a notch above zero at 0.1%.)
The Bank of England, like the U.S. Federal Reserve, has pushed back hard on the notion of negative rates as official policy. They want you to believe it will never happen.
But even if the BOE and the Fed hate the idea, the most realistic stance is “you never know.”
If the overall picture gets deflationary enough — meaning that overall price levels outside of shortage-impacted areas start to collapse — negative rates might become a necessity, in order to avoid a deflationary downward spiral.
Then, too, if longer-term bond yields go significantly negative across the board, which could happen on its own, the BOE and Fed might be forced to follow suit.
None of this is good news for expectations of quick recovery. Rather, the UK seeing its first-ever negative bond yield adds to the bearish message of the U.S. bond market.
Then, too, if the U.S. 10-year Treasury yield (currently at 0.70%) goes negative in the coming months, it would serve as a deflationary warning siren — and could trigger even wilder “printing press” type measures from the Federal Reserve.