This special guest commentary was written by our friend Daniel Lacalle
The amount of bonds with negative yield in the Eurozone and Nordic countries is higher than $4.5 trillion. The global figure is closer to $9.5 trillion. It is estimated that by the end of 2017, 18% of the Global Government Bond Index will have negative rates.
This means paying to lend to governments.
But, who buys these bonds and why?
Let’s first look at the environment.
“Financial repression” is the term used to identify a period of extremely low interest rates and artificial depreciation of the currency. It is the assault on the saver that involves diluting the value of money and its price with the questionable objective of forcing – hence the word repression – citizens to stop saving, and resume consumption and investment.
The peak of financial repression is real negative rates. Advocates of this practice justify it from the fallacious argument that saving is bad and that what you have to do is force economic agents to spend. If money is worth nothing, consumers will prefer to consume and companies will use their surpluses to invest even if profitability is poor.
However, it does not happen. Because many of these countries have exceeded the debt saturation threshold, with more than 225% of GDP of total public and private debt. Thus, financial repression achieves the opposite of what it intends. More repression, more saving, because economic agents perceive that overcapacity and debt remain as burdens and that the price and quantity of money is artificially manipulated.
Contrary to what the New Keynesians belief, extreme financial repression leads to even more cautious actions by economic agents in the real economy. A period of financial repression such as the present one, leads families and companies to save much more. Preferences remain focused on being conservative in the face of increasing uncertainty.
Why do citizens become more risk averse amidst expansive policies? Why do companies not invest more in the face of low interest rates and extreme liquidity?
Because they do not trust the economic environment and the reality they see differs from the sugar coated central bank-created image. Because the certainty of tax increases and the fragility of economies is not disguised by manipulating the amount and cost of money. Governments that increasingly consume more resources from the real economy make household consumption and private investment a high risk.
So who buys bonds with negative returns?
- Someone who thinks that the stock market and risky assets are going to collapse due to the liquidity saturation of expansionary policies and their low impact in the real economy. Therefore, faced with the possibility of losing 1% in a bond compared to losing, say 20-30% in the stock market or commodities, their preference is obvious.
- Those who assume that countries that do not participate in currency wars will see a strong currency relative to the one in which they invest. Say you buy Nordic bonds with negative yields and the local currency strengthens relative to the USD. The bond will be worth more from the currency move.
- Those who think that governments and central banks know how to get into quantitative easing, but have no idea how to get out. For this reason they expect to see further reductions in interest rates and more monetary expansion plans, which will revalue the low risk bonds further.
- Those who analyse these expansionary policies and currency wars and, instead of seeing inflation risk, estimate a greater deflationary probability, as the preferences for consumption and investment will not improve, they may worsen due to the lack of trust in central banks.
In short, contrary to what New-Keynesians believe, extreme financial repression leads to even greater caution -saving and divesting- . Meanwhile, the fragility of economies may increase if disposable income continues to be taxed away.
Financial repression only achieves the opposite of what it seeks to achieve. All it creates are short-term bubbles in risky assets.
Now, inflation is rising, causing a massive loss in nominal and real terms for those who invested in low yield bonds. This will impact pension funds, and at the same time central banks remain behind the curve unable to raise rates and moderate money supply. The recipe for stagflation.
This is a Hedgeye Guest Contributor note written by Daniel Lacalle who is an economist who previously worked at PIMCO and was a portfolio manager at Ecofin Global Oil & Gas Fund and Citadel. Lacalle is CIO of Tressis Gestion and author of Life In The Financial Markets, The Energy World Is Flat and forthcoming Escape from the Central Bank Trap."