The Mechanics of Negative Interest Rates
Earlier this week we discussed the bond market’s ominous message, while emphasizing a forecast for negative U.S. interest rates.
Scott Minerd is talking about negative interest rates, too. This is notable because Minerd, the chief investment officer for Guggenheim Investments, oversees $270 billion worth of assets.
In a note published on May 10, Minerd said the following:
I see the yield on the 10-year Treasury note falling to 25 basis points or lower very soon, with a possibility that it will go negative in the intermediate term—our target is -50 basis points, and in certain circumstances it could go meaningfully lower. The long bond could ultimately reach around 25 basis points as the 10-year and 30-year area of the curve shifts down by over 100 basis points from where it is today.
As of this writing, the U.S. Treasury 10-year yield is 0.73%. If it shifts down “by over 100 basis points,” as Minerd anticipates, it will go below zero (and thus turn negative).
For investors, negative prices are yet another head-scratching feature of a weird and bizarre landscape.
Not too long ago, we discussed the possibility of negative oil prices in these pages, pointing out at the time that the futures had never done it, but less-than-zero could happen soon. The piece was published on a Friday; the front-month WTI contract went to negative $37.63 the following Monday.
Negative yields for U.S. Treasury bonds would be another world-historic first, though Europe and Japan arrived there some time ago. At one point in the fall of 2019, nearly $17 trillion worth of sovereign bonds, including a portion of corporate bonds, had negative yields attached.
Negative yields came to other parts of the world first, but not the United States, because Japan has been in a deflationary funk for decades, and Europe has long been headed in that direction.
The U.S., in contrast, is seen as a more dynamic place — but not for much longer, perhaps.
In comparison to interest rate yields, negative pricing for commodities is fairly straightforward. There is a lot of oil in the world, and oil producers can’t shut off the taps without major headaches; therefore, with too much oil around, producers had to pay purchasers to haul the stuff away.
Interest rates work sort of like that, but the whole setup is more abstract. A bond is not a physical commodity that takes up space, but debt still has commodity-like features in that the price of debt is governed by supply and demand.
When the price of a bond goes up, the interest rate goes down and vice versa. This is not a correlation, but an iron-clad relationship: The price paid for a bond determines the yield that is received.
For example, if you pay one dollar (par value) for an eight-cent annual coupon, your yield is exactly 8%; if you pay more than a dollar, you will still only get a dollar in principal back (plus the eight-cent annual coupon) when the bond matures; and if the amount you pay is high enough, your total yield winds up negative, meaning you lost some money on the deal.
Through this mechanism we can see how yields are entirely a function of prices paid. They call bonds “fixed income” because the coupon (eight cents, in our example) is always fixed, meaning it always stays the same.
Yield is thus determined by where you buy the bond in relation to par, either above or below. The more you pay above par ($1, in our example), the less return you get — and at a certain price you lose money.
This leads to the next question: Why would purchasers ever buy bonds at a money-losing price? Buying something in order to lose half a percent, or whatever the negative yield is, seems about as logical as hitting one’s thumb with a hammer on purpose.
And yet there are logical reasons this happens.
First off note that, when it comes to government bonds, no person or committee decides to make the yield negative. Instead there is such a strong demand for the bonds that buyers keep bidding the price up, even after the yield hits zero and falls below zero.
As for why bonds still get bids when yielding less than zero, there are multiple possibilities for buyers’ rationale.
The first possibility is speculative price appreciation. If an investor buys sovereign bonds at a negative yield because he thinks the yield will go more negative still — meaning the bond moves higher in price — then he is simply looking to “buy low and sell high,” or rather “buy high and sell higher.”
Other investors, typically banks or large institutional investors, will buy negative-yielding bonds as a “least-bad alternative.”
By that meaning, these entities are forced by their charter or investment mandate to own some type of securities, or some mandated mix of stocks and bonds; if everything in their investment landscape looks terrible, buying bonds for a small fixed loss might be their “least bad” option.
Then, too, sometimes sovereign bonds see a rush of bids from safe-haven buying. When markets are in crisis, or there is otherwise a lot of turmoil, investors can rush into government bonds as a safe place to park their cash. If this happens in large enough volume, when yields were already low, the bond price can go negative and stay there.
It should go without saying by now, but negative-bond yields are a very bad sign for a nation’s economy, or the global economy on the whole when there is $10-$20 trillion worth floating around. This phenomenon means the long-run outlook for economic growth is so poor, or so worrisome, or both, that investors can think of little better to do with their cash than pay a holding fee to keep it safe.
The final, and most frightening, reason for negative-bond yields is the presence of outright deflation. If prices nearly all across the board are contracting at, say, a 5% annual rate, then losing 1 or 2% on a fixed basis — for investors with no better option — might actually be a good deal.
In sum, negative-bond yields are a harbinger of looming deflation and nonexistent economic growth. In a world overloaded with debt, such conditions can be so dire they inspire a printing press frenzy from the world’s central banks — but that is a topic for another day.