A Negative Space in a Positive Outlook


by Brad Houle, CFA Executive Vice President

Currently, nearly 30 percent of the world's sovereign debt has a negative yield. Said differently, owners of $7 trillion worth of government bonds issued by countries all over the world will get less money than they invested if they hold the bond to maturity.

Negative interest rates are a source of wonderment and frustration for fixed income professionals. Prior to the cycle, the commonly-held belief was that interest rates can only go to zero. Until recently, the employment of negative interest rates was to control capital flows in an attempt to stabilize currency. Now, negative interest rate policy (NIRP) is being used as an economic stimulus. The theory behind NIRP is that if banks are charged to keep money in their countries’ central bank, they will loan the money out or invest the money in a more risky asset in order to get a better return.

Some of our clients have asked if NIRP could occur in the United States. Treasury bill rates in the United States did go negative for the first time during the financial crisis. When investors panicked and fled money market funds, U.S. Treasury bills were a natural place for investors to hide. As the demand drove the prices up, the corresponding yields turned negative. This has briefly occurred on other occasions when there was a mismatch of liquidly and demand.

There has been speculation that the Federal Reserve could utilize NIRP if there was a recession or an external economic shock that required the Fed to step in and add stimulus to the economy. The concern is that monetary policy may not be “normalized” in time for the next recession. This is an unlikely scenario. Federal Reserve Chair Yellen said that negative rates were explored in 2010 and they were characterized as a strategy they do not want to consider. In addition, there is some question as to the legality of this approach.

This begs the question: Who is buying these bonds with negative interest rates and why? Some bond managers are forced to buy negative-yielding bonds due to flows of funds into the mutual funds they manage. For example, if a firm is managing an index fund that replicates the debt markets of countries experiencing negative yields and cash is deposited in the fund, the firm is forced to invest in bonds in markets that are outlined in the prospectus of that fund. In addition, many investors are restricted to investing in a very narrow slice of the bond market. Owning sovereign debt is important to banks due to regulatory capital requirements. This means that banks need to own high quality assets as part of their capital in order to makes loans to customers. Therefore, if you manage a bank in Germany, chances are you will need to own negative yielding German government bonds as capital.

Looking longer term, the implications of negative yields are unknown on the global economy. We believe that the domestic economy is still on solid footing due in part to the strength of the U.S. consumer, with consumer spending advancing 2.2 percent in 2015, unemployment now below 5 percent and real wages up 2.5 percent. In addition, government spending is growing for the first time since 2010.

Our Takeaway for the Week

  • Recent data reinforces that we are not seeing conditions that would trigger a recession in 2016