May 11, 2020
• Negative yields are here to stay in Europe and Japan, unless central banks start to implement untested and unconventional monetary policies.
• US monetary policy has many options under their current framework to combat the current downturn. The Fed is flexible enough to invent new policy tools before resorting to negative policy rates, even if the current downturn morphs into a depression.

Negative Yields are a Mystery to Many in Bond Markets

Resting on the desk of traders and portfolio managers around the globe is a copy of Frank J. Fabozzi’s 1983 book “The Handbook of Fixed Income Securities”. The 1,700-page volume is considered a foundational text for fixed income markets, covering a vast range of topics around bond markets. Despite its depth of coverage, negative yields are never mentioned in the copy. As negative yields become a regular fixture in the market, they remain elusive to many market participants, underscored by their absence in the most foundational literature about bond markets. Who would have thought that one day, investors would pay for the privilege to own a bond issued by a government, or more interestingly, by a corporate issuer?

Historic Background

Nearly 20 years ago, when Japan’s money market rates traded at a negative interest rate, many investors thought that it would never happen in other developed markets. Yet today, European countries including Switzerland, Sweden, Denmark, Germany and France, have seen negative bond yields. Even Emerging Market countries (based on MSCI’s definition) like Poland, the Czech Republic and Hungary recently joined the negative yielding club. Negative yields are not just a government bond phenomenon; even corporate bonds are trading at negative yields.

When yields go to sub-zero levels, mysterious things start to happen in the finance world. In Denmark, lenders started to offer mortgages to homeowners, which means repaying less than borrowed. In Germany, the entire yield curve, including the longest maturity 30-year bond, traded in negative yields. Even Greece, the country that forced significant losses to its bond holders during the European crisis, managed to issue negative yielding bonds last year.
In total, over $12 trillion in bonds that are part of the Bloomberg Barclays Global Aggregate Bond Index, an index that is widely used by fixed income managers as a global benchmark bond index, are offered in negative yields (Figure 1). Last summer, negative yielding bonds reached a high of $17 trillion in value.

Negative yielding bonds in Bloomberg Barclays Global Aggregate Bond Index reached $17T in value last year. The COVID-19 pandemic induced recession initiated another flight to safety, inflating negative yielding bond values again.

Where Do We Stand Today?

A culmination of factors has created the negative interest rate environment we see today. Central bank monetary policy rates that are in negative territory and massive quantitative easing (QE) programs that provided constant demand for bonds are the main culprits of negative yielding bonds globally.

This year, the previous peak of negative yielding bonds at $17 trillion could be superseded by the global economic impacts of the COVID-19. According to recent IMF estimates, the global economy is expected to shrink by 3% in 2020 and to recover strongly in 2021 at a 5.8% growth rate, assuming containment efforts are successful to stop the spread of the virus this year. Tourism, leisure and service-oriented European economies like Spain, Italy, France and Greece are expected to lose close to a tenth of gross domestic product (GDP), if travel restrictions continue during the usually busy summer time. This is a worrisome development for negative yielding bonds, particularly if European economic growth rates start to disappoint the direst expectations in upcoming months.

Will the US See Negative Yields?

On many occasions, President Trump encouraged the Federal Reserve to follow the ECB’s or BoJ’s lead in adapting negative interest rate policy. The question is, “What needs to happen to have negative interest rates in the US?”, or “Will it ever happen?”. In theory, the simple answer is; yes. There is a possibility that US interest rates could end up negative. For a brief period, 3-month Treasury Bill yields went negative during the financial crisis and during the COVID-19 related sell off in March, 2020. Fed fund target rates, even during the heights of the financial crisis, never went down to negative levels.

“Negative interest rates would certainly not be appropriate in the current environment. It is fact that, new normal is that central banks will have less room to cut. Low rates are not really a choice anymore; they are a fact of reality” ~Fed Chairman Jerome Powell on February 12, 2020 – Semi-annual Monetary Policy report to the US Congress.

There is a healthy debate among monetary policy experts on whether the US will have to introduce negative interest rates during this downturn.

The FOMC’s first line of defense is the Fed fund target rate. The Fed already used that ammunition by bringing the lower bound to 0%. Based on the playbook used during the financial crises, once the Fed fund target rates are at 0%, the Fed started to deploy logical next steps. These steps include: QE, guidance for future hikes and more importantly working closely with the US Treasury on creation of special purpose vehicles that allowed the Fed to purchase risky assets like corporate bonds, municipal bonds and even ETFs, as long as the risk is shared with the US Treasury. During the last recession, 25% of GDP was enough QE to restart the economy. This time, theoretically, the Fed can monetize the entire debt issued by the US government like BoJ is doing today for Japanese government debt.

And if none of the above measures work, a different policy framework will be required. Ideally, fiscal policy would take over. With multiple fiscal stimulus packages deployed in record time, the US legislature proved that it can act quickly when needed. Ultimately, fiscal policy has limitations as well, especially in an election year.

Dropping money from a helicopter was Milton Friedman’s idea in 1969, and it became a mainstream story after Ben Bernanke’s reuse of that term, earning him the nickname of “Helicopter Ben”, which he neither deserved nor wanted. We are not advocating or foreseeing that the US will utilize the so-called helicopter money approach. In the unlikely event of an unprecedented extreme depression that pushes inflation to extremely negative levels and the output gap to record highs, an emergency fiscal facility could be introduced that is financed by monetary policy. We would put a higher probability of that happening before introduction of negative policy rates in the US.

“Let us suppose now that one day a helicopter flies over this community and drops an additional $1,000 in bills from the sky, which is, of course, hastily collected by members of the community. Let us suppose further that everyone is convinced that this is a unique event which will never be repeated.” ~Milton Friedman, 1969

Bottom Line

This could be the crisis where central bankers will have to make a choice: continue with existing failed conventional monetary policies like targeting policy rates (including negative rates), yield curve controls and QE or venture out to untested and controversial monetary policies like retiring a portion of public debt or more boldly injecting liquidity directly to citizens. Until they decide to move into untested territory, negative interest rates are here to stay for the ECB and BoJ. The US monetary policy has many options under their current framework to combat the current downturn. Even if the current economic downturn were to become much worse (not our base case), the Fed has flexibility to invent new policy tools before resorting to negative policy rates.


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