By Michael Hampden-Turner, Director –Fixed Income and Multi-Asset Applied Research
Shakespeare liked a paradox and it’s what makes Hamlet famous. In contrast, investors would be more than happy to see the end the paradox of bonds with negative returns. When they first appeared in yen, swiss franc, euro and sterling, emergency meetings were held with sales and clients to explain how the paradox was possible: what investor would lend at negative rates? Since then, over the Covid period, half the euro investment grade corporate bond market has negative yields and everyone has got used to it (chart 3). The frustrating answer of ‘why’ in today’s complex wholesale market, dominated by regulation and central bank asset-purchase programs, is that it makes sense if it is the least bad option. But the machinery that created it is about to change, and negative yields are likely to start vanishing, albeit slowly. Quantitative easing (‘QE’) and negative deposit rates will likely reverse in 2022 and bond yields will rise in response.
In my earlier Elephant blog, we explored the connection between quantitative tightening (‘QT’) and higher rates. We warned that moving into a period of unwinding emergency monetary policy might be negative for fixed income.
The UK has set out its agenda for base rate rises and QT, and in the US, excitement about the reopening of the economy means that investors are looking for an optimistic four or five hikes this year. In contrast, Europe looks set to lag the UK and US, as economic metrics have yet to react as positively. Economic stimulation from asset purchases remains in full force until at least March, according to the ECB. Let’s remind ourselves of the scale and timing of this.
Over three trillion euros in bonds have been bought. At the same time policy rates have been ultra-low for some time as chart 2 illustrates.
It should be remembered that deposit rates are 50bp below those of policy rates. The result is that banks are both inundated with liquidity and ‘charged’ for deposits. Therefore, it makes sense to avoid having a cash balance. The least bad option is to invest in investment grade bonds, even if their yield is negative as it will still be cheaper for banks than having excess capital on deposit.
The result of reducing the supply of investment grade bonds, and essentially negative policy rates, is that most investment grade bonds followed policy rates into negative yields as investors held their nose and bought them anyway. During this period, more than 50% of euro investment grade bonds ended up with a negative yield (Chart 3).
However, better times in Europe are coming and investors are already starting to try and get ahead of policy changes. In the last few months, improved Covid prospects have helped to start to decompress European sovereign markets. The biggest beneficiaries of bond-buying programs have been the so-called ‘periphery’ bond markets such as Italy, Greece and Spain that have traditionally traded wide of ‘core’ markets such as Germany and Holland. A ‘rerating’ of risk here will have a knock-on effect on national banks, utilities and corporates.
Negative rates will not vanish overnight. It is unlikely that the ECB will be hasty in raising rates, even as inflation starts to edge higher. Equally, low rates can become habitual when they are low for very long periods, as in Japan. Therefore, negative yields might be on their way out, but it might be a slow process. As we started to explore before Christmas, this creates a dilemma for investors and the theme is likely to persist through 2022.
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