SWITZERLAND MAKES HISTORY WITH 10Y DEBT AT NEGATIVE YIELDS
There have been a lot of headlines recently about negative bond yields but last month, the Swiss Federal Treasury marked a new milestone when it sold CHF232m of 10y bonds at a yield of -0.055%. This is the first time a country has issued 10y bonds at a negative yield. Not even Japan, with its 25 year battle with deflation, has issued bonds at negative yields. If you were looking for a sign that investors believe European deflation is coming, then this is it.
The latest Swiss bond issue means that investors effectively pay the government to hold their money for 10 years. Why would investors do this, you ask? Well, it would seem there are a few possible answers.
Firstly, we know that many banks, funds, insurance companies and government agencies are mandated to invest a certain amount of their funds, if not all, in long term government bonds, regardless of the yield. This is usually for reasons of risk and liquidity. Added to this, the European Central Bank has also launched a huge round of quantitative easing by buying bonds from the market to flood the market with cash – in the process hoping that banks lend this cash to businesses and consumers thus keeping the economy ticking over and avoiding deflation. The ECB bond buying has created a shortage of bonds and pushed yields lower and lower as investors scramble to find fixed interest instruments to invest in. Another reason for investing at negative yields might be to speculate on the currency. If investors are fleeing the euro for Swiss francs it may be because they expect the Swiss franc to rise against the euro. In that event, an investor receiving a negative interest rate could still profit if the Swiss franc appreciates against the euro by more than it costs to invest in a Swiss bond.
If an investor believes that deflation is coming – that is the value of a dollar today will be less than the value of a dollar in future – then preserving capital becomes critical. And so long as the investment return (even if it is negative) generates a higher level of future capital than an alternative investment then the investor will be ahead.
Confused? Well it might be easier to think of it the other way around where an investor expecting inflation thinks the purchasing power of a dollar tomorrow will be less than the purchasing power of a dollar today. An investor would buy an asset today thinking that the asset will cost more in future. With inflation, the purchasing power of a future dollar is eroded.
In a deflationary environment investors want to do the opposite. They want to preserve capital because it can buy them more in future. If, for example, there is a deflation rate of 10% (where prices of goods and services decline by 10%) then an investor would be happy to invest at a negative interest rate of, say, 1.00%. Because the future value of a dollar invested ($0.99c) will buy goods and services at a 10% lower price.
The lessons from the Great Depression of the 1930s has seen central banks around the world battling to stave off deflation and mass unemployment. Whether large scale quantitative easing works or not is still unknown. The US has spent trillions of dollars to kick start their economy and avoid another Great Depression yet the latest inflation data (February 2015) suggests the US economy has not grown in the past 12 months. The jury on QE is still out but one thing is certain. We should all hope that QE works because it does not appear there is a Plan B.