No one knows how to back out without blowing up the whole system
By Wolf Richter | 29 June 2016
WOLF STREET — The amount of government bonds that sport negative yields – an all-too-real absurdity where bondholders in effect are shanghaied into paying the government for the privilege of lending it money – has soared 12.5% after the Brexit vote, from $10.4 trillion at the end of May to $11.7 trillion as June 27, Fitch Ratings reported today.
The action was in longer-dated bonds, with maturities of 7 years and over. Those with negative yields soared to $2.635 trillion, up 62% from the end of May and up 93% from the end of April, having nearly doubled in two months!
The German 10-year yield fell below zero during the period, now at -0.124%. Japanese yields are below zero all the way out to 17 years. And “virtually all” of the Swiss sovereign debt luxuriates in negative yields.
The short end, with maturities of 1-year an under, didn’t see that much action, with negative yielding bonds rising less than 1% in May and 5% in June, to $3.232, trillion. And negative-yielding bonds with maturities between 1 and 7 years edged up 2.4% in June to $5.849 trillion.
The amount of German bonds with negative yields rose by 8% and French bonds by 13%, to over $1 trillion each. And yet an amazing thing happened – despite Draghi’s best efforts: Italian bonds lost some ground, and those with negative yields dropped by $200 billion since the end of May, likely a reflection of “investor risk aversion related to Italy leading up to and following the Brexit referendum.” Ah yes, Italy’s banking crisis that is now advancing to the next level.
The amount of Japanese Government Bonds with negative yields jumped by 18%, to $7.9 trillion (about half of the increase of the dollar-denominated amount stems from the yen’s 9% appreciation against the dollar during the period). JGBs account for about two-thirds of all negative yielding sovereign bonds.
This is how absurd the situation in Japan has gotten: the 30-year yield ranged today between 0.05% and 0.094%, as close to zero as you can get visually when rounding to one decimal, without actually hitting zero. On Monday, the yield dropped to 0.044%, or rounded to one decimal: 0.0%.
The 40-year yield has ranged today from 0.075% to 0.112%! For debt that matures in 40 years! Given the current monetary policies – the BOJ has loaded up its balance sheet with ¥426 trillion of securities, or a mind-blowing 85% of GDP, and has no way of stopping it without throwing Japan into a horrible debt crisis – well, given these policies, there is practically no chance that the yen in its current form will not have blown up by then.
But investors don’t care.
Let me correct that: investors aren’t buying the JGBs anyway. The only entity that is buying on a net basis is the BOJ. Everyone else is selling. And when these investors slow down their selling just one notch, even as the BOJ continues mopping up every JGB that isn’t nailed down, yields fall further.
What does this mean for investors that bought bonds with long maturities years ago? For example the German 4.75% Bund, issued in 2008 and due in July 2040 trades at 202.3 cents on the euro, having doubled its value over the past eight years. The sellers of those bonds are the true beneficiaries of Draghi’s monetary policies, and they can sell them right to the ECB.
But long-term investors, like insurance companies and pension funds, hold bonds to maturity to create predictable income streams to pay for predictable benefits decades down the road. They’re going to get face value for these bonds when they’re redeemed. And 30-year bonds that these insurance companies and pension funds are now buying have a yield of 0.32%. Next to nothing!
They’re completely screwed. Or rather, the regular folks who are supposed to get these payouts in the future are completely screwed. Fitch put it this way:
The increasing amount of long-term negative-yielding debt underscores the challenges faced by large bond investors such as insurance companies that need to match long-term liabilities with similar maturity assets. As more of the global universe of safe assets drops into negative-yielding territory, income for these investors continues to fall.
No one has any idea how to get out of it. Right now, everyone is still just focused on getting ever deeper into it. Because that’s where the short-term profit is: even more negative yields!
Where does that leave our Federal Flip-Flop Reserve that has been jabbering about raising rates since 2014 and has managed to raise them only once, by one tiny increment, six months ago – now that it has admitted that central bank actions around the globe are connected and cross-contaminate their respective bailiwicks.
At the beginning of the year, the Fed expected four rate hikes this year. At the beginning of June, it was down to two. And now?
“The Fed Funds futures are putting a 0% chance of a hike in the next four months and just a 8.6% chance of a hike in December,” explained Christine Hughes, Chief Investment Strategist at OtterWood Capital. “Interestingly, traders now see a 13.8% chance of a cut in September or November before any hikes”:
It seems everything that happens in this world – Brexit is just another event in a long list of such events – pumps up the prices of government bonds and pushes down their yields, as frazzled central bankers resort to lowering rates even further and buying even more bonds, to counteract the very forces that their harebrained, scorched-earth policies have unleashed, and as investors no longer know where to turn to, in a landscape where nearly all assets are ludicrously overpriced and infested with risks. And no one knows how to back out of it without blowing up the whole system.
But there are some consequences for the real economy. Business optimism in the US is already “lowest since the height of the Financial Crisis.” Read… How Vulnerable is the Shaky US Economy to Brexit Fallout and European Bank Meltdown?