Davide Buccheri; Negative yields are pushing the ECB into a corner

Negative yields are pushing the ECB into a corner

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Money supply in Europe has been in an astonishing uptrend for the past 20 years now, driven by extremely expansionary monetary policies. The latest innovation in this field was introduced in late 2013, when the ECB announced that it was ready to cut interest rates into negative territory.

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More recently, the incumbent ECB President, Christine Lagarde, has signalled her intentions of further lowering rates. However, this move might be short-sighted and potentially pushing the ECB further into a corner from which it is becoming extremely difficult to get out, without massive market turmoil.

Policy objectives

First of all, it isn’t at all clear how negative rates would help the ECB pursuing its monetary policy objectives. The ECB has as its main target price stability above all. This is quantified as an inflation rate below but close to 2%.

It is debatable whether the ECB was successful in its objectives so far, as “close” is a vague term. The yoy monthly inflation rate as measured by CPI has been quite volatile and often into negative territory, but mostly under the 2% threshold. Nonetheless, the general consensus is that the ECB has struggled to sustain inflation well enough.

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In this context, I don’t think that negative interest rates are a useful tool. I find at least two significant arguments against their use.

The first relates to the prices of assets. If an investor buys today an asset for a price of, say, 103, with the promise of receiving 100 in the future, it means that prices are literally declining (i.e. deflation). Of course, this will create some inflation in the short-term (as prices jump from 100 to 103), but this cannot be sustained for long.

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In order to keep inflation at high-enough levels, the central bank would need to continuously slash interest rates, thus repeatedly engineering instantaneous inflation.

Another way of looking at this same issue is that the value of €103 today will be equivalent to €100 at maturity: money is growing in value. An economic side effect of this is that people will invest less: if my money grows in real terms by doing nothing, why bother? If instead of investing my €103 in the markets for €100 in the future, I keep them under the mattress, I’m better off. This also negatively affects the second monetary objective of the ECB: sustaining growth.

The second main issue I see with the use of negative interest rates relates to inflation expectations. In this regard, we’ve got a quite useful instrument at our disposal in inflation-linked treasury bonds. For my analysis, I combined data from Banca d’Italia and MOT to look at the yields on Italian BTPi’s, which are linked to European inflation, and compared these to the Italian yield curve to extrapolate the implied inflation.

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The chart above shows how implied inflation is significantly below the 2% target until at least 2041, levelling off at 1%. Data from the Deutsche Finanzagentur also supports the idea that long-term inflation is expected to level off at around 1%, with the 30-year inflation-linked iBund showing an implied inflation of 1.18%. This is a quite strong indication that investors are not convinced that the current monetary policy pursued by the ECB will be able to successfully generate inflation.

It is debatable whether deflation is necessarily a net negative. However, this is clearly not in line with the objectives of the ECB and more thought should be put on the implications of the current monetary policy in this regard.

Market impact

The more concerning consequence of negative rates is a significant inflation of bond valuations. Negative rates have always been referred to by the ECB as an exceptional measure. This implies that, at some point, they plan to reverse it.

However, this is becoming more and more difficult as time goes by. The more yields are pushed lower, the larger the market impact of any attempt to bring them to reasonable levels will be. And investors are quite good at reading the intentions of central bankers, which means that any hints of ending this negative rate policy could result in a quite dramatic jump in yields.

This is clearly different from the past. Previously, when rates were increased, investors were left to wonder at what level the central bank would stop. Now, on the other hand, the answer is starkly clear: 0%. If the policy is reversed yields will first go to zero and then move towards an unknown policy level. This will allow investors to move quickly and decisively, causing a potentially large swing in market values. This alone might make it extremely difficult for the ECB to reverse its policy.

It is easy to see this looking at Germany. At the moment, according to its Treasury department, Germany has €741.5bn of outstanding long-term government securities. At current market values, this balloons to €954bn. All of it is currently trading at a negative yield, with almost €600bn trading between -0.75% and -1%.

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As we have a lot of data available for Germany, it is easy to model how a jump in yields would affect the market value of their debt. Given the duration of 9.1 of the outstanding German debt, we have:

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To have every long-term German government bond trading at a non-negative yield, we’d need a 1% increase in rates. This by itself would be sufficient to wipe out €80bn, or around 9% of their current market value.

Extending this process to the wider European market paints a dangerous picture. Data from the BIS shows that as of the end of 2018, €16tn of debt were outstanding in Europe. Unfortunately, this data is nominal, rather than at market value. This means that the estimates that follow are actually quite conservative, since spreads have recently tightened and a significant amount of new debt was issued. To put this into perspective, according to data by Bloomberg, in the period January – June 2019 around €1.3tn of new negative yielding bonds were issued. This compares to around €270bn in the whole of 2018.

Assuming a duration of 9 years for government debt (in line with Germany) and of 5 for corporate debt, this is the market impact we would experience for different jumps in yields:

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This tells us that just to bring all debt into positive trading territory, we’d need to wipe €1.2tn of market value.

In addition, with an increase in yields we’d also expect an increase in spreads. Assuming that this widening affected only corporate bonds and that it was uniform, the total market value loss would jump to a staggering €1.4tn (with a 50bps increase), or €1.6tn (with a 100bps widening in spreads).

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Importantly, Italy would be one of the markets hit the hardest, with a potential loss of between €216bn and €257bn in market value (without accounting for sovereign spreads widening). This might cause panic to spread across markets, with further widening in spreads. France and Germany would also be significantly hit, with potential impacts of between €277bn and €376bn for the former and between €217bn and €293bn for the latter.

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At this point, it is useful to bear in mind that I believe these estimates to be relatively conservative, as outstanding nominal values, instead of market values, were used. In addition, sovereign spreads were kept constant across the Eurozone. Using Germany once again as an example, we have that the market value of Bunds is currently around 28% higher than nominal values. Applying that same ratio to our estimates would move our potential loss from €1.6tn to €2.1tn. This is probably a reasonable upper limit for the current market.

There is, however, one last item to consider. By their very definition, negative yielding securities are destroying investors’ wealth as time goes by. According to the Bloomberg Barclays Global Agg Negative Yielding Debt Market Value Index, there are currently around €11.7tn of securities with an average negative yield of -0.31% and duration of 5.1 years. This means that, with constant yields, investors would suffer losses of around €36bn a year.

In order to prevent such losses, yields would have to decline further, providing some price appreciation to oppose the economic amortisation of bond prices towards par.

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The chart above shows the evolution of yields necessary to keep the market value stable through time. Focusing on the €11.7tn currently outstanding, as their maturity approaches and duration declines, yields would have to fall to -1.44% to prevent all losses. Even assuming that new issuance would keep the duration stable at 5.1, yields would still need to fall considerably, to -0.63% to prevent losses. The problem is further compounded by the fact that, as yields decline, more and more securities will fall into negative territory.

This creates an incentive for investors to push yields down further and further, in the hope that they’ll be able to make a profit on their investments. Combining this with the incentive the ECB has to do the same in order to engineer inflation, we get a dangerous mix, where everyone needs lower and lower yields to survive. This clearly cannot be sustained in the long term.

Conclusions

The ECB has indicated that it intends to continue pursuing its expansionary policy of negative interest rates. This seems problematic both in terms of its objectives and market impact.

As for the former, the objective of the ECB is to keep inflation just below 2%. Negative rates can help to create inflation in the very short term, but also seem to suggest that deflation should prevail in the long run, which is against the stated target. The only way the ECB can get around this for some time is by slashing rates repeatedly. This is a dangerous approach, as it compounds the long-term deflationary effects. In addition, negative rates also seem to be a disincentive to invest, which violates their secondary policy objective of sustaining growth. The yields on inflation-linked BTPi’s and iBunds also suggest that expected inflation is significantly below the ECB’s target.

As for the latter, in order to bring all yields back to zero, a 1% increase in rates would be necessary today. This could wipe between €1.2tn and €2.1tn, depending on what assumptions are used. This is still a manageable market impact (for comparison, the 2007 financial crisis wiped more than $10tn in the S&P 500 alone). However, the more time goes by, the further into negative territory yields go and the bigger the impact of reversing this policy will be. We also need to consider that investors are generally smart: as soon as they sense a change in policy, they’ll run for the door. This would obviously cause widespread panic.

There are also a number of additional factors to keep in mind (e.g. squeezing of bank margins), which make negative rates even less attractive. As an outside observer, it is concerning to see the ECB pushing forward without any clear exit strategy able to properly tackle these issues.

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