The gift of ultra-low interest rates in the pandemic
A few days ago investors lined up to pay the British government for the privilege of lending it money. Nearly $5 billion of UK Gilt bonds were issued at a yield of -0.003% on May 20. Let that sink it: a negative interest rate. If a person had even voiced this possibility out loud pre-2008, he/she would have been laughed out of town.
It’s still remarkable, but actually no longer a wholly novel situation given that the German and Japanese governments have been issuing negative-yielding debt for some time now. US government bond issues still have a positive yield, but just barely.
Why are investors paying to lend to these governments? And what does it imply for fiscal policy and the prospects for post-pandemic economic recovery? The bond market can be awfully complicated, but I will zero in on what I see as the top three reasons.
Lower-for-longer central bank rates
First, central banks have driven their respective policy rates to near-zero (the Federal Reserve and Bank of England) and below zero (the Bank of Japan and the European Central Bank), and are expected to keep them low for a long time. The extremely low policy rates exert a gravitational pull that anchors interest rates across the economy, including those on government debt. It’s kinda like the Death Star’s tractor beam pulling the Millenium Falcon towards it.
Disinflation & private sector surplus
A second related factor is the dire inflation and growth outlook caused by the Covid pandemic and oil price collapse. Inflation is the bête noire of government bond investors. When you are lending money at X%, and the prices of things around you are going up by X+%, well then the debt you have invested in is really losing value. Inflation, or to be precise unexpected inflation, is a Dementor that sucks out all the happiness and hope from holding a bond. So low expected inflation facilitates the gravitational pull of central bank policy rates on bond yields because investors are not induced to demand higher rates to account for the inflation risk.
A deep economic recession also tends to drive up savings by households and firms. When people are uncertain about their job prospects, they are unlikely to be spending money freely. Companies will similarly refrain from expanding and investing in gusto when business is uncertain. Both households and firms will instead tend to focus on paying down their debts. So higher private savings in tandem with falling demand to borrow money will drag down interest rates.
Safe asset shortage
Third, there is a global shortage of “safe assets” for global investors. Safe assets have stable payoffs with minimal credit risk, and are easily bought and sold in financial markets. The stock of a private company, for example, is not a safe asset because the dividend payoffs can never be assumed to be stable, plus bankruptcy is never a zero probability. A real estate property is not a safe asset either because it cannot be bought or sold in the blink of an eye, apart from the question of whether one may rely upon steady rental payments. Safe assets are rare, and you can count the securities considered such on your fingers.
Safe assets are basically limited to the government debt of stable countries with effective administrations that issues debt in their own currency. When you are able to issue debt in your own currency, then you are less likely to default because you can always print your currency. Of course, another danger arises, so it helps if you have a credible central bank that is independent of direct political pressure.
There are many who complain about the US government’s growing debt pile, currently at an astounding $25 trillion or more than the annual GDP. But it is also worth noting that American net household wealth stands at $118 trillion. The US is an extremely wealthy country, and has an effective government that can levy taxes. Whether the government chooses to raise taxes is another question, but the point is that it can, and that ability provides comfort to investors.
There is an acute shortage of these safe assets — basically US, German and Japanese government bonds, maybe British too — in uncertain and turbulent times. Global investors are clamoring to buy these securities, and are doing so in competition with central bank purchases through their respective QE programs. So increased demand colliding with limited supply results in lower bond yields.
A fiscal-driven recovery
The combination of low central bank policy rates, disinflation, weak growth outlook generating a private sector surplus, and the safe asset shortage have conspired to produce these anomalous negative bond yields. The ability of these countries to raise money at near-zero or negative rates opens the door wide for continued deficit-financed fiscal policy to support livelihoods, businesses and the simple promise of a prosperous future.
This opening might indeed be one of the drivers of the strong rebound in the equity market in the past two months, as investors take note of the ability to continue fiscal pump-priming at little to no cost.
Desperate times call for desperate measures. Governments who are privileged by financial markets with near-zero or negative bond yields should grab this gift, and use it to spur the post-pandemic recovery. And if yield curves start to steepen as a result, then that’s another gift as it will help the banking sector and keep the economy’s financial arteries open.