The Invesco White Paper Series Invesco Fixed Income Negative Yields in the Eurozone: Rationale and Repercussions When in 1 the European Central Bank (ECB) introduced a negative deposit rate, this was not the last of Mario Draghi s unconventional measures. In January 15, a large scale Quantitative Easing (QE) program was announced, pushing many interest rates into negative territory. We will analyze the consequences of these controversial measures on the eurozone financial markets as well as the real economy. Mark Nash Head of Global Multi-Sector Portfolio Management Nicholas Wall Portfolio Manager Rob Waldner Chief Strategist Invesco Fixed Income In June 1, the ECB showed its resolve when it introduced a negative deposit rate to help turn the eurozone economy around. Under this extreme monetary easing measure, European banks began paying for the privilege of storing cash with the ECB, rather than receiving interest on their deposits. Since the deposit rate had already been zero, this was the next logical step. The move was intended to incentivize banks to lend their excess reserves to consumers and businesses in the hope of boosting growth and inflation, instead of holding them at the central bank. As negative interest rates flowed through the financial system, the rationale was that it would also boost credit assets across the eurozone and potentially cause the euro to fall, as global investors sought higher returns in the eurozone and eventually outside of Europe. A lower euro could help boost growth and inflation through cheaper exports and more expensive imports. Since then, more than just the ECB deposit rate has gone negative. Yields are now negative on 6% of core Europe s outstanding government bonds (figure 1). Figure 1 Government Bonds Yields Negative Positive Selected countries Switzerland Germany Denmark Austria Finland Netherlands Belgium France Sweden Italy Norway Poland Spain UK Maturity in years 1 5 6 7 8 9 1 Source: Bloomberg L.P. Data as of March 1, 15. Negative yields do not apply only to government bonds. In some cases, blue chip companies are issuing new debt with negative nominal yields. In essence, investors are willing to enter into an investment where, on a hold-to-maturity basis, they will receive back less than originally invested. On the face of it, it defies logic that a rational investor would behave this way so how did we get here? And what are the macroeconomic consequences and risks of negative interest rates in Europe?
How did we get here? The eurozone s recovery, post-global financial crisis, has lagged. Inflation has consistently run below the ECB s desired target of around %, growth has been stubbornly low and unemployment stubbornly high. 1 The ECB had already taken tentative measures along the way primarily aimed at promoting bank lending. But these moves had failed to make a significant or long-lasting impact, in our view. Despite the availability of cheap ECB financing, the weak state of eurozone banks curtailed their ability to lend on to the broader economy (figure ). In 1, global and domestic deflationary pressures pushed European inflation down and threatened outright deflation across the eurozone (figure ). A negative deposit rate was a bold move to reboot the ECB s monetary stimulus program. Finally in January 15, the announcement of large scale QE (the ECB s 1 trillion euro bond-buying program) has further intensified the negative interest rate phenomenon. As ECB demand for bonds has pushed bond prices higher, bond yields have been forced lower, ultimately into negative territory. Figure Eurozone Loan Growth Failed to Take Off Loans to non-financials M M1 Monetary aggregates and loan growth (January 8 = 1) 1/6 1/7 1/8 1/9 1/1 1/11 1/1 1/1 1/1 1/15 16 1 1 1 8 Source: Macrobond. Data as of January 15. Figure Eurozone Inflation Hovers Well Below the ECB s % Target Core inflation (ex-food and energy) Headline inflation % 1/ 1/5 1/7 1/9 1/11 1/1 1/15 5 ECB inflation target 1-1 Source: Macrobond. Data as of February 15. Deleveraging post-global financial crisis has hindered growth Deleveraging has been a large drag on eurozone growth and inflation, in our view. Post-crisis, the eurozone has undergone intensive balance sheet repair and is now a saving economy (figure ). Intensive deleveraging can be seen in the private sector as households pay down debts rather than spend, and corporations accumulate cash reserves and reduce leverage, rather than invest. This has pushed consumer savings relative to spending and corporate savings relative to investment to unprecedented levels. Similarly in the public sector, the budget imperatives of the monetary union have forced Brussels to push for budget deficit reduction meaning less potential for government borrowing and spending to support growth. Germany, the only large viable borrower in the eurozone with its solid fiscal position, is showing no willingness for fiscal expansion. Figure Growing Eurozone Current Account Surpluses Indicate Economic Weakness, Not Strength Eurozone France Germany Italy Portugal Spain Current account balances as % of GDP 9 6 - -6-9 -1-15 Q1/99 Q1/1 Q1/ Q1/5 Q1/7 Q1/9 Q1/11 Q1/1 Source: Macrobond. Portugal, Spain, Italy, eurozone: data from Q1/1999 to Q/1; Germany, France: Q/1999 to Q1/1. Latest available data. Slow growth and the risk of deflation are very negative for economies with high debt loads. With limited ability to grow or inflate out of a debt overhang, an economy s debt and debt service burden can become onerous. The eurozone s toxic combination of low inflation, low growth and high leverage justifies very expansionary monetary policy including negative interest rates.
What does the ECB hope to accomplish? With negative deposit rates, the ECB is trying to incentivize European banks and investors to take on more credit risk on the basis that negative returns on low-risk investments should incentivize greater risk-taking to obtain greater potential returns. We have seen this dynamic working through Europe and even outside the eurozone into Denmark and Sweden and more broadly into the UK and the US. And the recent ECB bond-buying program makes the impact even more powerful. What has been happening in markets? We can see the effects of the ECB measures in the flattening eurozone government yield curves (figure 5). Facing a negative return on cash, investors are naturally expected to move out the credit curve to improve returns potential on their assets, in theory, easing financial conditions for less creditworthy borrowers in the process. Figure 5 Yield Curves are Flattening They do Not Price in Reflation Yet German -year yield German 1-year yield Spread (RHS) 1/6 1/7 1/8 1/9 1/1 1/11 1/1 1/1 1/1 1/15 % % 5 1 1..8.6... Source: Bloomberg L.P. Data from January, 6 to April, 15. Negative deposit rates and ECB QE are likely to cause large swathes of the benchmark German government yield curve to go negative. Because the alternative investment is a negative deposit rate of -.%, buying German government bonds at negative yields higher (less negative) than this doesn t seem as punishing for investors. With negative deposit rates of -.75%, Switzerland and Denmark are more extreme examples. Swiss and Danish five-year interest rates are already trading at -.% and -.1% respectively. In a globalized world where money is free to travel across international borders, investors have also been taking positions in very low or negative yielding debt in the hope that it will go more negative and achieve capital gains. On the same basis, other developed markets have also been affected, as investors hunt for yield in areas where domestic fundamentals do not appear to justify lower yields. All this has contributed to increasingly low interest rates in many smaller European markets with very reasonable levels of economic growth (Sweden and Poland for example) and, in general, lower yields globally (the UK and US for example). Indeed, negative interest rates combined with current account surpluses, may lead to a flood of euro outflows, as investors seek higher returns abroad. The eurozone s weak domestic demand has resulted in a current account surplus of roughly % of GDP per year, meaning that every year Europe has, in effect, % of GDP to invest. 5 With investment alternatives shrinking at home, and liquidity already looking for yield, we could see a tremendous amount of European investment funds finding their way overseas in the coming years. Will the ECB policy be effective and what are the risks? The effectiveness of this ultra-easy policy is questionable for Europe, in our view. Excessive risk taking could be a problem, as investors lend at yield levels that do not compensate for the potential risks, making capital available for unworthy borrowers. Bubble markets can develop that could destabilize the financial system. In Europe, the situation with negative interest rates is especially dire since regulation requires strict levels of fixed income investment among pension and insurance companies. Negative interest rates and very low yields can make it increasingly difficult for pension and insurance companies to match future guaranteed returns. Underfunding and missing return targets may damage these companies equity returns, lead to insolvency or even end up costing the taxpayer.
In terms of the potential impact on credit creation, the majority of eurozone credit is created via the banking system, which is still reeling from the heavy losses from the financial crisis. Capital ratios are impaired and so are banks lending capabilities. Harsher capital requirements on lending are also impeding lending to the small businesses that create most of the jobs in Europe. As interest rates fall into negative territory, bank margins will also likely compress, further reducing banks desire to lend. The supply of credit is thus unlikely to increase much, in our view, regardless of ECB policy extremes. Given these headwinds to growth, negative interest rates seem likely to be with us for a long time. Looking abroad, the ECB s strong reaction to the eurozone s fundamental problems may create serious consequences for all developed central banks. Lowering the attractiveness of cash and fixed income assets in the eurozone produces capital flows into other currency areas and pushes down the euro foreign exchange rate. These flows force up other countries currency rates verses the euro, and, in doing so, hurt their export competitiveness and push down import prices. Given the size of the eurozone relative to these smaller local markets, it is a difficult task not importing Europe s deflation. At a time when global inflation is running around % lower than recent historical norms, this can put pressure on smaller central banks to curb currency strength and reduce the attractiveness of cash and fixed income assets in their currencies. 6 Little wonder that Switzerland, Denmark, Sweden, Poland, Norway, Hungary and Czech Republic have all cut policy rates this year and the US and the UK have sought to limit higher interest rate expectations. The ECB s size and might is influencing other central bank policy. Conclusion The ECB under Mario Draghi has been much more proactive than in the past. The central bank is attempting to ward off deflation by putting money in the hands of the public and corporations in order to encourage spending. Previous ECB efforts to boost the amount of money in the system met with limited success, in our view. Policy rate cuts did little to disrupt the intensive balance sheet adjustment underway. The longer-term financing operations (LTRO), reliant on the banks for takeup, proved successful for only a short period of time and did not have the desired impact on the non-financial private sector. Finally, in June 1 deposit rates were dropped into negative territory and in January 15 a large-scale sovereign bond buying program was announced and introduced two months later. Through this extreme policy action, bond yields have moved into negative territory across large parts of the European sovereign bond curve universe, as investors now pay governments for the privilege of lending them money! With more money in the financial system due to the expansion of the ECB s balance sheet, and interest rates low or negative, the central bank is aiming to maximize the chances that monetary policy will stimulate demand. While negative interest rates are extraordinary, the functioning of the eurozone financial system does not yet appear to be impaired. Higher asset prices and shifts in global portfolio and foreign exchange flows are underway. But the impact on the real economy remains to be seen. 1 European Central Bank, April, 15. Bloomberg L.P., April, 15. European Central Bank, April 15. Bloomberg L.P., March 1, 15. 5 Macrobond, as of December 1, 1. Latest available data. 6 Bloomberg L.P., March 1, 15.
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