QE, negative yields and the paradox of thrift

LONDON Thu Jul 19, 2012 10:34am BST

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LONDON (Reuters) - The investment world is tying itself up in a string of paradoxes spun by pervasive economic and financial fear and its resultant central bank bond-buying and money-printing.

The spread of negative yields on debt from government borrowers perceived as the safest may well be forcing lenders and investors to tip-toe into longer-term securities and less credit-worthy debtors just to try and recoup the face value of loans despite the higher risks assumed.

In a world where the once novel idea of negative interest rates is fast becoming commonplace, even achieving a capital-preserving zero return is now almost akin to a high-yield bet.

But even though yields are being crushed in part by monetary policy aimed at relieving the stress, the wider effect of the collapse of bond yields may have the opposite effect on the economy, forcing aging savers to save even more.

"Instinctively (negative returns) should be good for consumption if it means consumers spend today, rather than saving for tomorrow when their assets are worth less. But things may not be so straightforward," HSBC's Global Head of Asset Allocation Fredrik Nerband told clients.

Nerband argued that as investment and pension returns decline in line with government bond yields, consumers facing low or negative returns may actually be forced to save more than normal to bolster inadequate pension provisions.

"This is the proverbial paradox of thrift. And it has an impact on demand."

Nerber argued that, assuming low 2 percent investment returns and 1 percent annual salary increases over the next 30 years, a 40 year old person today with a full year's salary saved and planning to retire at 70 would need to save almost a third of their current salary until retirement just to secure a pension worth 60 percent of final salary until death at 85.

If households in rapidly aging western societies consume even less as a result of this, then economies slow further, compounding sovereign debt demands, increasing central bank bond buying and money printing and further increasing demand for paltry-yielding securities.

The potential vicious circle is clear to see.

PAY TO LEND

So how widespread are negative yields becoming?

On Wednesday, Germany for the first time sold two-year bonds with zero percent interest rate coupon and a price above par that meant the annual yield to maturity was negative to the tune of -0.06 percent.

In other words, investors fearful of lending to anyone else because of the uncertainty surrounding the euro's future and global economic slowdown are willing to accept a guaranteed loss in return for the privilege of lending to Germany -- which they assume can and will pay them back at face value come what may even if its now charging a fee to do so.

As if to underline the demand to do so, bids for the bonds were twice what was on offer.

But Wednesday's auction was just another milestone in the collapse of yields across the euro zone and the United States, where 3-month Treasury bill yields are just 0.1 percent and 10-year bond rates are less than 1.5 percent.

And even though part of the reason for the demand for safety over returns is uncertainty about the future of the euro zone, it's not just Germany that's borrowing for less than nothing.

Dutch and Finnish government debt securities are trading negative out to mid-2014 maturities. French Treasury bills are in negative territory also and Belgian bills were marked at negative at auction for the first time on Tuesday.

"This is remarkable," said Padhraic Garvey, interest rate strategist at ING, adding that since Belgium and France were under such severe pressure in October/November last year the Belgian 2-year bond yield premia over Germany have fallen from 460 basis point to juts 35 bp now and France equivalents have fallen from 140 bp then to 24 bp.

But this widening of the search for safe "core" or "semi-core" assets to avoid negative nominal yields -- yields have been negative in real or inflation-adjusted terms for some time across the western world -- may have the perverse effect of easing some of euro stress problems they are trying to avoid.

Spanish and Portuguese short-term bill yields also fell at auction this week and Ireland returned to bill market this month for the first time since its bailout in 2010.

"If there is an appetite to head back into French and Belgian paper, we feel such appetite should extend to the likes of Italy which looks to us to be a significantly better bet than the stressed Spanish story," said Garvey.

HOW LONG?

But if the cumulative effects of central bank money-printing and bond-buying, or quantitative easing, and extraordinary central bank actions like the European Central Bank cutting its own deposit rate to zero last week are all driving forces behind collapsing yields, then there is unlikely to be any let-up.

Even though Federal Reserve Chairman Ben Bernanke stayed relatively tight-lipped on the prospect of more QE in his latest testimony to Congress on Tuesday, he did outline the options left open to the Fed and investors worldwide still widely expect the Fed to act again -- if not before, then shortly after November's presidential elections.

Bank of America Merrill Lynch's latest monthly fund manager survey on Tuesday concluded: "The firm conviction from investors is that central banks will (have to) respond with further policy easing, the question being not if but when."

Some 71 percent polled expect more QE from the Fed by the second quarter of next year and 73 percent of managers expect the ECB to engage in more direct large scale quantitative easing over the same period.

"The half-life of the response to different QE measures has diminished for the Fed but it's not out of bullets. No central bank that has the ability to infinitely expand its balance sheet is out of armoury," said Peter Fisher, head of fixed income portfolio management group at giant U.S.-based money manager Blackrock, which manages $3.56 trillion (2.27 trillion pounds) in assets.

The question is whether QE is starting to do more harm than good and there there's little or no policy consensus.

(Editing by Jeremy Gaunt.)

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