Paying for the privilege of lending

Investors who wish to buy Swiss government bonds and would like to be repaid within 4 years, now have to accept not a low interest rate, nor even a zero interest rate but a negative interest rate. That is to say the lender pays the borrower real money for the privilege of lending. Similarly in Germany, a 2-year bond was recently issued with a 0% coupon, and on June 1st was trading in the market at above 100 – investors were happy to guarantee a loss if they held the bonds until maturity. Elsewhere government bond yields in the US and the UK are trading at just about their lowest ever levels – lending to governments has never been a less well-rewarded activity and this at a time when governments owe more money than ever before. Greece, has just defaulted, and the media are full of stories of sovereign credit risk. The fundamentals would indicate that this is a very risky time to be lending to governments but most can borrow large amounts very easily and at astonishingly low interest rates.

For Germany and Switzerland the reason for the negative yields is the rising expectation of a potential break-up of the Euro. The Swiss Central Bank has publicly stated that it will print unlimited amounts of Swiss Francs to ensure its currency does not strengthen further against the Euro. However this is not believed by the market due to the long history of conservative Swiss monetary policy. If the Euro were to break up, the demand to convert Euros into Swiss Francs would be enormous, and far greater than the Swiss Central Bank would be prepared to supply. Similarly in the event of a Euro break-up, Germany could be relied upon to have the currency that the world would want to hold. So the negative yields on offer represent the cost of the implicit currency option in the event of a Euro collapse. Germany is the more risky bet here, since it remains the case that one of the few remaining solutions to the crisis, is a much deeper European level of fiscal and political integration in which Germany does assume some liability for the debts of the other nations. If this occurs, Germany’s creditworthiness deteriorates and it may well lose its AAA status.

For the UK and the US, bond yields are positive but are negative in real terms after adjusting for inflation. Yields of around 1.5% over 10 years are below the respective Central Banks’ targets of 2% for the UK and 2.5% for the US. Yields this low are manifestations of demand factors as both the Bank of England and the Federal Reserve have bought large quantities of government bonds with newly printed money. Further the commercial banking systems of both countries have been forced to have much larger holdings of government bonds to bolster their balance sheets. Investor sentiment has been steadily more cautious over the last year, moving away from equity investment and towards more conservative instruments. For most individual investors though, who have to pay tax on the bond coupons, most government bonds  offer negative after-tax yields, even before inflation.

Recent dramatic declines in government bond yields outside the Eurozone periphery, are indicating that the next Euro crisis is close to hand, with attention shifting away from the Greek elections and towards who will recapitalise the bankrupt Spanish banking system. Currently Germany is against every possible solution – it is opposed to (i) common Eurozone bonds, (ii) infrastructure-spending bonds, (iii) bailing out other countries banks, (iv) reducing the drive towards fiscal rectitude, (v) a huge deficit-financed boost to public spending, (vi) the ECB printing money and (vii) any country leaving the Eurozone. Several of these are becoming mutually exclusive, and Germany will have to choose.

Elsewhere in the world, the recent economic news from the US, China, Brazil and India has been disappointing. Growth is slowing and there appears no rush from any policymaker to do anything about it other than to re-iterate their strong desire for growth to occur. Behind the scenes, concern will be growing and some policy action (quite probably co-ordinated) is likely in the next 2 months. This would be good news but may first require a crisis to bring it about. Equity markets are very oversold and cheap if one believes that growth will return again in the near future. Much negative news is priced into financial markets. Longer-term investors can begin to buy some equities at current levels, those with a higher risk aversion may prefer to see the crisis before adding to positions.

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