Has the world gone mad?
A significant chunk of the investing population is now willing – apparently – to pay governments for the privilege of lending to them.
According to JP Morgan, reports the FT, around 16% of government bonds had negative yields last week.
In other words, if you buy one of these bonds, and hold it to maturity, you end up getting back less money than you invested in the first place.
It’s like lending an acquaintance £100, then telling them – “you’re such a good credit risk, and inflation is so low – I only need £95 back”.
So what’s going on?
Why would you buy a bond with a negative yield?
Buying a bond with a negative yield sounds like a stupid idea on the surface. So let’s think about why you might do it.
Firstly, bonds bought from developed-country governments that can print their own currencies are safe assets – in nominal terms. In other words, if you buy then hold the bond until maturity, you know exactly how much money you’ll get back.
The biggest risk is that inflation will take off, and the amount of money you get back is worth a lot less in real terms than when you bought the bond. But if inflation doesn’t look like much of a problem (and right now it doesn’t), this might not worry you.
And the shorter the time to maturity (ie until you get your money back), the less this matters – that’s why longer-term bonds tend to have higher yields than short-term ones.
So although the upside may look limited, so does the downside. If you’re feeling worried about the future, or you need somewhere relatively safe to put a large amount of money, a bond offering a reasonably predictable level of mild downside could be attractive.
This is particularly the case when many central banks are turning deposit rates negative. So if you’re a bank, and you have the choice between being charged to hold cash with the Swiss central bank, or buying a Swiss government bond with a slightly lower charge – well, why not buy the bond?
Secondly, it’s a way to bet on currency movements. A Swiss government bond might look like a poor investment if you’re living in Switzerland. But if you would like to own Swiss franc assets because you think the franc is going to keep rising against the euro or the dollar or the pound – or whatever your home currency is – then buying Swiss government bonds offers a way to bet on this.
But maybe it’s just a bubble
Thirdly, there’s the ‘greater fool’ theory. Because bonds are quoted in terms of their yields, it’s easy to forget that they are just like any other asset – as well as a yield, they have a price.
Our brains short circuit somewhat when we see that yields have turned negative. “How can that number go below zero?” we think.
But prices can just keep going up. If you have to buy a negative-yielding bond at £110 – well, who cares, as long as someone else will buy it back off you at £111?
That might look kind of daft. But it’s how bubbles always work. And to be fair, there are a lot of potential greater fools out there. Central banks are price-insensitive buyers. They’ll take a negative-yield bond off your hands no problem.
And as Niko Panigirtzoglou of JP Morgan notes on FTAlphaville, passive bond funds will unquestioningly buy negative-yielding bonds too – they just have to. So that’s another price-insensitive buyer.
But there are also signs that this is self-reinforcing.
Look back to bubbles of the past. The Japan bubble and the (admittedly apocryphal, but plausible) story about central Japan being worth more than the entire state of California. The tech bubble, and investors being willing to pay millions for companies that were little more than scrawls on napkins.
These bubbles all started with rational ideas backing them. But eventually, there was no rational reason for buying this stuff, except that it kept going up. And in turn, because it kept going up, people then tried to invent fresh new ‘rational’ reasons to explain this away, because as human beings, we hate to exist in a world that we don’t understand.
That’s why “this time it’s different” stories are such a warning sign – they’re a sign that things have got so far out of whack with reality that people are desperately wrestling to find ways to make sense of it all. When in fact, the simple truth is that it doesn’t make sense.
To me, ‘secular stagnation’ theory and the general idea that we’re in some sort of ‘new normal’, or that we are failing to make any sort of worthwhile technological progress, is a form of “this time it’s different” story.
What could pop the bond bubble?
The most obvious pin for any bond bubble would be inflation returning. Or interest rates rising more rapidly than anyone expects. Or both.
Why might that happen? It’s not easy to say. But it is odd, when you think about it, to live in a world where we’re talking about being close to full or at least normal employment in the major economies like Britain, the US, Germany and Japan, and yet we’re also fretting about deflation and lack of wage pressure. Can that continue?
And there are plenty of other potential triggers. Dr Pippa Malmgren talks to Merryn Somerset Webb in the latest issue of MoneyWeek magazine, out now, about why she expects an inflation shock. If you’re not already a subscriber, you can get your first four issues free here.
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