An informative article on negative interest rates

I liked this article because it gives the real consequences of negative interest rates. These consequences are very important and may very well rattle the financial markets.

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10 Things to Know About Negative Bond Yields

Feb 27, 2015 5:00 AM EST

By Mohamed A. El-Erian

 

As yields on German bonds plunged further yesterday, with some maturities closing at record negative levels, the worldwide trend toward ultra-low interest rates remains largely intact. Yet the causes and implications of this movement are quite complex. Here are 10 things to know, from the well understood to the speculative.

1.        Although German bond markets are leading this historical phenomenon -- more than 30 of the 54 securities in the Bloomberg Germany Sovereign Bond Index are at negative yields -- other European government markets also are increasingly seeing ultra-low yields dip into negative territory. JPMorgan has estimated that as much as 1.5 trillion euros ($1.7 trillion) of euro-zone debt trades with negative yields in a growing number of countries, including Austria, Denmark, Finland, Germany, the Netherlands and Switzerland. Moreover, this isn't limited to the secondary market; some countries have issued debt at negative yields.

2.        “High quality” European fixed income markets aren't unique in experiencing an extraordinary period of ultra-low yields. Peripheral government bonds, such as those issued by Italy and Spain, have been trading at record low yields, as have corporate securities issued by companies such as Nestle and Shell.

3.        The seemingly illogical willingness of investors to pay issuers to borrow their money is neither irrational nor driven by just noncommercial considerations (such as regulatory requirements or forced risk aversion). As the European Central Bank prepares to start its own large-scale purchasing program next week, some investors believe they could make capital gains on such negative yielding investments.

4.        There are many immediate reasons to justify this investor optimism. The impact of the ECB’s quantitative easing program (whose scheduled purchase of government bonds is likely to run into a relative scarcity of supply) is amplified by still-sluggish growth, “low-flation” and the threat of deflation. Geopolitical developments also play a role, along with messy national and regional politics in Europe.

5.        These immediate drivers benefit from a supportive secular and structural context that ranges from the dampening effects of demographics to the impact of technological innovations and growing inequality.

6.        Although they may be a boon for many companies’ liability-management programs, these ultra-low interest rates are a challenge for banks and providers of long-term insurance products. This may have consequences for the services they are able to provide to their clients: For example, a growing number of European banks are now charging depositors for holding their funds.

7.        This provides further evidence that what happens in government bond markets does not stay there. The spillover effects also include a weaker euro, compression of other bond spreads and a boost for equities. It also means flatter European yield curves as the cascade effect of negative yields gradually extends to longer maturities (Japan is an historical example of this).

8.        Developments in European markets translate into a more intense tug of war for U.S. Treasury investors. On the one hand, lower European yields pull Treasury yields lower; on the other hand, better U.S. economic performance, together with the widening gap in monetary policy prospects between the Fed and the ECB, encourage divergence.

9.        There are few analytical models, and even fewer historical examples, to help understand the broader economic, financial, political and social implications of all  this -- particularly for a global financial system based on the assumption of positive nominal rates. We are truly in unchartered waters.

10.    The ultra-low interest rate regime is likely to persist for now. In the medium-term, this historical and highly unusual phenomenon is likely to bring not just possible benefits for the European economy but also much higher risks of collateral damage and unintended consequences. Accentuated by the illusion of market liquidity, this is a world in which small adjustments in probabilities of future outcomes -- if and when they occur -- could result in sharp movements in asset prices.

 

Source: Bloomberg