Negative yields are on course to cost the market a trillion dollars, says Goldman Sachs. Editor-in-Chief Michael Wilson explains the tortuous reasoning in this month’s rant.
Now, it’s very possible that the whole of what follows will have been sorted out by the time you read this. In which case, just relax. The global financial markets will have woken up, looked their lurking nightmare in the eyes and turned the lights on for long enough to send the bogeyman back to the darkness where he belongs. And then we can all turn over and get back to making money.
Then again, maybe not. And in case you haven’t guessed, I’m not talking (for once) about Donald Trump’s chances in the November presidential elections, or about Theresa May’s gloomy quandary in Europe. I’m discounting the chances of a North Korean Armageddon, and I’m assuming that China will still be plugging on in its usual sleepwalk toward economic prosperity. I’m not even supposing any massive disruptions to the demand for oil, or the price of iron ore or gold, although they’re in the mix as well.
No, what bothers me more this month is a piece of straightforward mathematical logic. That is to say, it would be straightforward if only the problem weren’t so huge, so hard to measure – and so damnably difficult to follow. I am of course talking about the Curse of the Negative Yield. Or negative interest rates, if that makes you feel any more comfortable. (They’re not the same thing, but they inter-relate closely.)
They say that you can boil a frog without it noticing, as long as you do it very, very slowly. Not a very pleasant metaphor, I’ll grant you, but bear with me. Over the last seven years or so, a key theme from the world’s central banks has been boosting the world economy through a form of hidden subsidy that we’ve come to call quantitative easing. As a substitute for growing the economy in any more conventional but painful way. A spoonful of sugar helps the medicine go down, and all that.
The idea behind QE is simple enough, and the recipe has been broadly the same in America, in Britain, in continental Europe and Japan – you simply print more money, use it to buy back a huge pile of government bonds, and try not to worry about a bit of inflation, because with luck the renewed economic growth will cover your tracks and the future generations who’ll eventually have to pay for it won’t mind too much.
Does that sound cynical? To be fair, there’s a good case for saying that (most) QE has been highly successful in keeping the wheels of industry turning during the lean years since the 2008 crash. (We might need to make an exception for Japan, but otherwise it holds true enough.) And what’s more, all that new paper has come with one enormous advantage: QE has driven down the costs of borrowing in ways that have become so ubiquitous that the frogs have hardly noticed the steady change in the water temperature.
Until now, that is. Bank of England governor Mark Carney isn’t the only person on this side of the Pond who’s now fretting about the failure, despite the QE bonus and a 0.25% base rate, to get inflation up to the kind of 2% target that would normally denote a decently moving economy. And over in Frankfurt they’re worrying about very much the same thing, except that Germany’s bond yields have actually been dipping into negative territory this year.
Whereas in the relatively bullish United States, by contrast, the Federal Reserve is talking about raising interest rates instead. And that’s where things get really complicated.
Running out of magic bullets
The first problem with sub-zero bond yields and zero bank rates, wherever they happen, is that you don’t just run right out of magic bullets with which to stimulate growth – you also change the whole logic of keeping cash in liquid form. With yields as low (and conversely, with bond prices as high) as they are at present, a bond investor may be forced to accept that he has no hope of getting his money back on redemption day, because the price he pays to buy them now might well be more than the combined value of the face value and all the coupon payments for the remaining term. The bond is a guaranteed loser.
So why should he decide to buy it, even though it’s an obvious dud? Perhaps because it forms part of his company’s core capital. Perhaps it’s mandated by the rules of his fund, so he has no option but to stock up on it. That’s the second problem.
Either way, he’s paying for the privilege of lending the central bank his money. And the same, by extension, goes for savings interest. If you want your spare money (or your tier 1 capital) safely stashed, it’ll cost you hard cash in interest rates to the lender – oops, sorry, no, I mean the borrower. That might even make you think twice about holding any spare cash reserves on your books at all, which might not be such a great thing if it reduces your liquidity. As it will…
Thirteen trillion dollars’ worth of trouble
But we digress. By the end of August, according to the Financial Times, there were more than $13 trillion of sovereign bonds worldwide that were trading with negative yields, up from $12 trillion in June (Bloomberg). And to that you can probably add $100 billion of negative corporate bonds – the latest firm figures I could find were $36 billion in June 2016.
Let’s put that into perspective. The world’s stock markets are worth (very approximately) $80 trillion, and bond markets are estimated in the region of $150 trillion, with the great majority made up by either government debt or paper from financial institutions. (Non-financial corporate bonds are comfortably less than a fifth of that subtotal.)
On those figures, then, we are reduced to the uncomfortable thought that one in twelve of the world’s bonds – and one in six government bonds! – have been in negative territory this autumn. A prospect that PIMCO’s former bond king Bill Gross described back in June as “a supernova that will explode one day”. While Goldman Sachs warned, also in June, that even a 1% upturn in bond yields this autumn could spark a trillion-dollar loss for bond investors.
Making sense of those numbers
How would that work, then? To put it simply (and I should warn than I am no trained economist), investors who’d overpaid for ultra-low-yielding paper would find themselves with book losses which it would be impossible to sit on until happier times returned, because bonds really don’t work that way.
A 1% increase in yields could be sparked quite quickly if the Federal Reserve were to get its timing wrong. But even if it didn’t, the business consensus appears rather bleak. A Bloomberg survey in June suggested that ten year yields on US Treasury debt would rise from 1.7% in the mid-summer to 2.6% by the third quarter of 2017; Goldman Sachs itself was guessing 3.3% by 2018.
Just a trillion dollar drop in the ocean?
And another thing. A trillion dollars might look small against a global bond volume of $150 trillion or so, but as a loss it would hit the financial institutions especially hard – meaning, perhaps, that lending could be squeezed. A trillion would, according to Goldman Sachs’s analysts, be more that the entire realized losses on non-guaranteed mortgage bonds since the financial crisis. “Some investor entities would likely experience significant distress,” wrote Marty Young, one of the authors. “Rising yields should be on the short list of scenarios to be monitored by risk managers.”
Hallelujah to that. But what’s this? Fed chairman Janet Yellen has been weighing up her moment for a belated hike in US interest rates – having been forced to call off her last raise last December. Indeed, it seems that the only thing keeping her at bay until now has been a modestly disappointing set of US growth figures.
That may, of course, have become a fact rather than just a fear by the time you read this. And if you’re looking for a reason why Wall Street stumbled in September, that’ll be it. So what’s next?
The 8th November presidential election, of course. And more worries for Germany’s Chancellor Angela Merkel. And Brexit, and Kim Jong Un’s next military move, and the stuttering oil price, and the fallback even in bullion markets. Hold onto your hats, it’s going to be quite a ride.