How much more loopy can the financial system get?

Japan's new ten-year government bond carries a negative yield. It's guaranteed to lose investors money. John Stepek looks at how we've come to this, and what could burst the bubble.


Bank of Japan boss Haruhiko Kuroda: is his quest to drive inflation higher doomed?

In the annals of financial oddities, Japan has achieved many firsts.

This morning, it did it again. Japan sold a ten-year government bond (JGB) on a negative yield.

It's the first time on record that it's happened, reports the Financial Times.

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It's an event that calls to mind many questions, primarily - who would be daft enough to invest in this?

The three reasons you might buy a negative-yield government bond

Just to be clear this isn't a bond trading in the secondary market. This was a fresh auction.

In other words, the Japanese government went out with the begging bowl and said: "Can you lend us some cash?"

And investors said: "That's very decent of you, what will you charge us?"

Anyone who bought this government bond, and who holds it for the entire ten years, is guaranteed to lose money (in nominal terms, at least). Not a huge amount admittedly. But still.

If your financial adviser told you that he'd seen a great opportunity that was guaranteed to lose you 0.024% a year (before fees, naturally), you'd be less than impressed.

So the whole thing sounds loopy. How can this be happening?

But when you give it a bit of consideration, it's not quite as weird as it sounds. You're just being thrown by that negative interest rate. We've discussed this before, but it's worth revisiting.

There are three reasons to buy a government bond with a negative interest rate. All of them are rational they may not be sensible, but they are rational.

Firstly, there's currency speculation. In this case, what you're really buying is the yen. The bond itself just happens to be a convenient way to do it. So, as a foreign investor, you buy the ten-year JGB as a way to bet on the yen getting stronger. Your capital gains come from betting on the currency.

Secondly, there's "greater fool" buying. Just because the bond yield is currently negative doesn't mean that it can't get even more negative. Investors have proved to be remarkably stupid in the past. In the late 1990s, investors flocked to buy stocks that were bereft of dividend, profits, or in some cases, even sales.

Framed by that level of gullibility, it doesn't seem all that hard to believe that the price of a government bond which is backed by the third-biggest economy in the world might go even higher than it is today (remember, as bond prices rise, yields fall). In short, you might happily buy JGBs, believing that this is a momentum bubble trade, and you'll be able to get out of it before the next sap comes along.

Thirdly, you might genuinely believe that you have no better option. If interest rates are negative on other "risk-free" (I'm using the inverted commas to denote sarcasm, in case you hadn't already twigged that) assets, and inflation is low or non-existent, then perhaps you think that locking in a small nominal loss on a ten-year JGB is acceptable by comparison.

This is clearly a bubble. What could burst it?

As you'll have noticed, two of these are speculative the owners don't plan to hold for ten years. And the other requires the buyer to have faith in quite an extreme scenario that there's a good chance that there's nothing better to do with your money than accept a small guaranteed loss.

In other words, it's all the sort of thing you typically see around a bubble. And I do wonder what might pop that.

I can't imagine, for example, that Bank of Japan boss Haruhiko Kuroda is terribly happy about the strengthening yen, or the idea that investors are flocking to stick their money in JGBs, clearly believing that his quest to drive inflation higher is doomed.

I doubt that this is what he had planned when he turned interest rates negative in the first place.

In Richard Koo's book on balance sheet recessions, he makes a point that has stuck with me ever since I read it. He argues that one way for central banks to create inflation against the backdrop of a balance sheet recession is to convince markets that they are unhinged enough to do "whatever it takes" to get things going again.

We've already seen some pretty unhinged actions from central bankers, and not just in Japan. Yet markets are still to be convinced.

What comes next? Apparently sales of safes are booming in Japan, as people worry about how much more negative rates could get. But maybe we'll see a different form of radical monetary policy.

How about outright debt monetisation? Taking the bonds already on the Bank of Japan's balance sheet and cancelling them? That would send a pretty clear signal to everyone.

My colleague Tim Price has been talking about the dangers of increasingly desperate central banking a great deal recently. If you haven't already seen Tim's thoughts on the current state of the monetary system, they're well worth a read find out more here.

John Stepek

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.