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This week, Germany managed to sell a batch of interest-free government bonds.
That is, the German government popped along to market and said: “We’re looking to borrow money – just over €3bn in fact – for ten years. We will pay you 0% interest, and no, that’s not an introductory offer, that’s going to last for the entire ten years. Who’s up for it?”
Take a wild guess as to how it went.
The upside-down bond market
Lend money to the German government, interest free?
I mean, sure, it’s a good credit risk. But surely there must be something better you can do with your money than lend it at absolutely no interest.
So you’d think that this Bund issue would have gone down like a lead balloon. Instead, of course, because we now live in the financial equivalent of the Upside Down, Germany managed to get the bonds away with a negative yield of 0.26%.
In other words, it’s not just an interest-free loan. It’s better than that (for the borrower). At -0.26%, the amount the lender gets back at the end of the ten years diminishes a tiny little bit, every year.
Perhaps the craziest thing about this is that it wasn’t even the first time Germany has been able to do this. It’s the second time. The last came in the immediate wake of the Brexit vote in 2016, when bond prices spiked higher (and yields spiked lower) in that year’s final burst of deflationary panic.
However, a -0.26% yield is a new record low for German ten-year borrowing costs at issuance.
Perhaps the irony is that this is far from the weirdest thing happening in the bond market. Another example is the fact that some ostensibly far riskier debt is also trading at negative yields. Certain “emerging” European countries for example.
A quick recap on credit risk and government debt: if you lend money to a country that can print its own money (has control of its own central bank), then there is no nominal credit risk.
So when you buy debt from the US, for example, or the UK, you are not taking any credit risk (or as close to zero as you can). You will definitely get paid back. Whether the money you get back is worth the same as the money you put in is another matter. But in nominal terms, you won’t be defaulted on.
If a government is borrowing in a currency that it can’t print, though, that’s a different matter. If a government can only issue pounds but its debt is denominated in dollars, then it can run into trouble, as has been demonstrated over and over again across the decades.
This is why emerging markets sometimes run into problems with accelerating inflation and end up defaulting. They issue dollar-denominated debt, and their own currency then collapses against the dollar, driving up borrowing costs sharply.
So regardless of how solid the issuer is, any foreign currency-denominated debt has to carry some credit risk with it. Therefore it’s weird that – as the FT reports – all of the Czech Republic’s euro-denominated debt, “now trades at sub-zero yields”.
What does this all mean? Why is it happening? And how long will it continue?
Markets are hoping to front-run central banks
We’ve discussed this topic before, of course, but it’s so outlandish that it bears constant revisiting.
Soaring bond prices (and the resulting collapsing bond yields) clearly don’t reflect the present reality. Negative yields might make sense if prices were falling. If prices are falling, then you can make money in real terms (ie, taking account of inflation), even if you lose it in nominal terms. But even in the most deflation-prone economies, prices are at worst, flat.
So are they predicting the future? I mean, you can certainly argue that rates may stay low and that inflation may never come back, and that maybe we’ll have a deflationary bust. But the least extreme scenarios already look as though they’re priced in, and the most extreme seem highly unlikely.
So what are the alternatives? There’s the assumption that central banks will continue to prop up the market, which does make sense as a rationale, even if it’s still betting on something that might not happen. Particularly in the eurozone, where there is arguably a shortage of the most important debt – the German Bund.
Germany is an indebted country, but, compared to the rest of us, it’s less indebted. That means it doesn’t have as many bonds washing around out there as some of its peers. But as the safest credit risk in the eurozone, there’s also lots of demand for its bonds.
More importantly, if the European Central Bank does decide to restart quantitative easing (QE) then the natural owners of German Bunds, along with all the other eurozone-denominated debt, will be competing with a massive, price-insensitive buyer again. So there’s certainly an element of front-running the central banks here.
You can see that by the fact that – interestingly – yields have actually risen a bit (and prices fallen) in the last couple of days as the economic news has been that bit better from the US and even in the eurozone.
I think this is where the big risk lies. Markets have worked themselves into a recession-fear froth, whereby they now have a lot staked on central banks cutting interest rates and embarking on looser monetary policy.
I can’t see central banks disappointing investors at this stage, but if the news improves even a little bit or there are signs of inflation finally taking off, then that’s when bond investors might start to change their minds. Given that their investments are currently weighted so heavily over in one direction, that could cause a lot of turbulence when they switch.
This is another topic we’ll be looking at in a lot more detail at the MoneyWeek Wealth Summit in November. Yesterday we bagged another very exciting guest for the summit – I won’t share his details with you yet but we’ll have an update soon. Book your ticket now so you don’t miss anything!