If financial theory is grounded in one principal, it’s the “time value of money,” or the idea that individuals prefer consumption today over consumption in the more uncertain future.
In order to encourage the deferral of consumption, borrowers must pay lenders, and it has always been assumed that interest rates are “bound at zero”. But as has repeatedly been the case since the financial crisis, the theory is being challenged by the practice.
The last year has seen a proliferation of bonds trading with a negative yield, mainly in Europe. In effect, creditors are having to pay in order to lend money, and this has a number of implications for investors.
Currently, 25% of the European sovereign bond market is trading with a negative nominal yield. In France, government bonds of up to 3 years carry a negative yield; in Germany, bonds up to 8 years do; and in Switzerland, bonds up to 10 years. Even more striking, there are examples of corporate bonds with a negative yield. For instance, back in February, yields on the bonds of Nestle turned negative.
Why would anyone pay to lend money? There are several reasons, most a function of the unusual economic environment prevalent in Europe.
First, negative yields may make sense if you expect a significant decline in prices. Under deflation, real (or inflation-adjusted) yields could be positive even if nominal yields are negative.
Second, yields may become even more negative, which allows for profit potential for those willing to sell before maturity. This scenario could happen, as the European Central Bank (ECB) is struggling to find enough bonds to buy in order to meet its 60 billion euro/month quantitative easing (QE) quota.
So, given Europe’s sluggish growth and low inflation, and the fact that European QE will continue for at least another 18-months, what does a persistent regime of negative yield mean for investors? Here are three implications.
- Lower rates on U.S. Treasuries. While low European rates don’t represent a ceiling for U.S. yields, they are suppressing U.S. rates. It’s hard to reconcile a sub-2% U.S. 10-year yield with the current strength in the U.S. labor market. Part of the reason U.S. yields remain this low, even as the economy recovers and the Federal Reserve (Fed) prepares to raise rates, is that U.S. bonds look attractive to investors in Europe and Japan. The relative value in U.S. bonds is leading to cross-border flows that are driving U.S bond prices higher and yields lower.
- A stronger dollar. Attractive U.S. rates, and the accompanying capital flows, are one reason the dollar is, while off its highs, still up over 8% year-to-date.
- Outperformance for European yield plays. I’m cautious of U.S. income plays, but in an environment of negative yield, income-producing stocks in Europe have a natural edge. Plus, their valuations are less stretched.
The bottom line: The last six years have involved a non-stop guessing game of how low interest rates would go. Most of us assumed that there was a lower bound. It turns out we were wrong.
(c) BlackRock Investment Management