How negative can interest-rates go?

by Anthony B Sanders

A consequence of the credit crunch era that has continued to flow is the trend towards negative interest-rates and yields. For example it was only the week before last I was looking at a speech from Bank of England Governor Carney that referred to there being some US $13 Trillion of negative yielding bonds. Then last week I noticed that some developments are somewhat mindboggling. From The International Financing Review.

The distortion of the credit markets by central banks has produced the ultimate oxymoron: negatively yielding high-yield bonds.

About 2% of the euro high-yield universe is now negative yielding, according to Bank of America Merrill Lynch.

That percentage would rise to 10% if average yields fall by a further 35bp, said Barnaby Martin, European credit strategist at the bank.

So we now need a new name for what we used to call high-yield bonds. I guess junk bonds still cuts it although even it feels a bit awkward. We even got some examples.

Irish paper packaging company Smurfit Kappa (BB+/BB+), for example, has a €500m 3.25% June 2021 bid at -0.012%, according to Tradeweb data.

 

American metal packaging Ball Corporation (BB+ from S&P) also has bullet bonds in negative territory. Its €400m 3.5% December 2020s are quoted at -0.003%.

As you can see the negative yields are marginal but we have learnt that these things have developed a habit of starting and then spreading. Especially as we note what is driving it.

He said the first signs of negative yielding high-yield bonds emerged about two weeks ago in the wake of Mario Draghi’s speech in Sintra where the ECB president hinted at a further dose of bond buying via the central bank’s corporate sector purchase programme. There are now more than 10 high-yield bonds in negative territory.

Personal Injury Claims

This morning my own country the UK has shown how negativity if I may put it like that is spreading into other areas. From Reuters.

Britain’s Ministry of Justice said it plans to change the discount rate applied to personal injury lump sum compensation payments to minus 0.25% from minus 0.75%, it said on Monday.

The decision follows a review started by the Lord Chancellor earlier this year and follows lobbying from auto insurers, whose profits were hit by the decision to cut the so-called ‘Ogden Rate’ from 2.5% in 2017.

As you can see the Lord Chancellor was apparently having the mental equivalent of a nap in the period from 2009 to 2017 as interest-rates and yields plunged. So the legal profession I suppose lives up to its reputation for being out of touch. But the serious point is one we have looked at regularly which is how do you make provision for the future when you are facing negative returns which are increasingly permanent. I doubt their Lordships look at it like this but this is another consequence of the UK Index-Linked bond or Gilt market being eye-wateringly expensive. Why? Well in an era where conventional bonds are so expensive investors drove the price of linkers up as well because otherwise they offered more yield.

So the natural place to invest much of a compensation payment is seeing its own outburst of negativity as real yields have been negative for a while. The issue is complex as Stewarts Law who were one of the few to think this rate would stay negative seem to have a rose-tinted view on wage growth.

This makes it impossible to ignore the long-standing economic phenomenon of earnings-related inflation rising faster than prices inflation.

 

How low can things go?

I am reminded of a research paper by the Bank of Japan which I looked at on the 24th of last month. Let us look at it from a different perspective.

In the second economy, the marginal shock occurs on top of an innovation to the Taylor rule that, on its own, would depress the policy rate to about -1% on impact. The
reversal in loan rates has been crossed at this stage.

The refer to an interest-rate of -1% more than a few time suggesting they think that it is as low as you can realistically go. This is as ever not about you and I but about fears for what more negative interest-rates would do to the banks.

with the evidence documented in Ampudia and Heuvel (2018), who document that the response of banks’ stock valuations to monetary policy shocks changes sign as the
level of interest rates decreases.

Also and this gets increasingly relevant as the credit crunch drags on things get worse as time passes.

However, these assets mature, making net worth
more sensitive in subsequent periods. Second, the impaired deposit rate pass-through as policy rates decrease substantially lowers bank profitability, especially as rates enter negative territory.

This leads them to this.

We have shown the conditions for the existence of a reversal interest rate, the rate at which monetary policy stimulus reverses its intended effect and becomes contractionary.

This should not be a complete surprise as the Bank of Japan has never really been much of a fan of negative interest-rates. It cut to what we would call ZIRP territory (0.5%) in late 1995 and did not go negative until January 2016. Even that was to a mere -0.1% as the bank’s natural caution collided with the zeal of the political appointee Governor Kuroda. Indeed it has stuck to the -0.1% level for what it calls “yield-curve control” which means that in the recent plunge in bond yields it has been holding Japanese ones up rather than down. This means that if we do end up living the lyrics of the Vapors. life may not be what many assume.

I’m turning Japanese
I think I’m turning Japanese
I really think so
Turning Japanese
I think I’m turning Japanese
I really think so

Comment

This brings us back to the issue of the long-term and the future. That is really rather different in a world of persistent negative interest-rates and yields. Think of a pension which is by definition a form of saving for the long-term. How does that work if you receive an illustration telling you that if you put £1 in you will get £0.9 back? Losses were always possible especially in real or inflation adjusted terms but the concept of expecting to lose is very different. On this road to nowhere fewer people will bother to save for the future? I recall in the early part of this century pension illustrations which suggested 5%,7% and 9% so let me throw this out there what do readers think they should say now?

We know the trend and yet the sporting world reminded only yesterday that life is complex and far from simple. New Zealand were the better cricket team but fate conspired against them as an overthrow went for six, Bottas found that a safety car turned up just in time for  Lewis Hamilton and Federer somehow lost in spite of playing so well. As an England cricket fan I was delighted with the result but could not help wondering if the Black Caps had run over a black cat on the way to Lords.

Still at least we can rely on the banking sector.

A Dutch social housing co-operative a decade ago bought €3bn derivatives from Deutsche Bank & went almost bust when they turned toxic. It later emerged that co-operative’s treasurer was systematically bribed. Deutsche now settled lawsuit for €175m ( @OlafStorbeck ).

As the the reversionary interest-rate I think we went into it as the credit crunch began and have never come out. That is why to coin a phrase it goes on and on and on.

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