Actively Speaking Podcast

Negative Interest Rates: How we got here, who's buying bonds, and what it means for banks

September 19, 2019 Epoch Investment Partners Episode 7
Actively Speaking Podcast
Negative Interest Rates: How we got here, who's buying bonds, and what it means for banks
Show Notes Transcript

Negative interest rates have been a distinguishing feature of the Japanese economy and many European economies for some years now, but how did we get here? Who would buy a bond with a negative yield? And how do they impact the profitability of banks? Epoch Senior Research Analyst Nikolay Petrakov answers these questions and more on Actively Speaking. (September 19, 2019)

Speaker 1:

Hello, and welcome to Actively Speaking. I'm your host, Steve Blyk. Join us each episode as we discuss current issues concerning capital markets and portfolio management from the perspective of an active manager. Hello, and welcome to another episode of Actively Speaking. My guest today is Nick Petrak. Nick is an analyst here at Epic Follows Financial Services Stocks. Uh, and I know Nick has been here almost five years because, uh, Nick started two days after I did<laugh>, uh, in November of 2014 at Epic. And I know that because of course, you know, the, the newest employee has to raise the flag every morning, sing the company song, make the coffee. So I, I only had to do that for two days. Uh, I had one of the shortest tenures as, as the newest employee. Uh, okay. So what we're gonna talk about today is a phenomenon that I think most of us years ago when we started our careers, would've thought we would never see, which is negative interest rates. And right now there's something like$17 trillion in debt. I think that's the number I've heard recently that carries a negative yield to maturity right now. You know, just seems like in a bizarre phenomenon here, I'm, I'm gonna buy this bond, and I know that between now and when it matures, I earn a negative return. Uh, it, it just seems baffling. So we're, we're gonna look at three things. Number one, how do we get here? Uh, number two, who's buying who, who would buy a bond with the negative yields? And, and number three, uh, more perhaps pertinent to from an investing point of view is, uh, what does this mean for banks? Uh, so let, let's dive right in. So, Nick, how, how did we get here to this situation where we have negative yields on so much

Speaker 2:

Debt? Yeah. Thank you, Steve. So clearly it is a, a, a very strange phenomenon, and there's been plenty of discussions around academic circles and professional circles as to, um, the need and, and, um, the development of, of the phenomenon. I'm gonna take a step back and, and kind of discuss a couple of, um, kind of structural reasons and couple of, uh, cyclical reasons for this. Clearly, it's been a long term in the making that negative freight environment. So the first structural reason is, is really, really the productivity gains that we've achieved over multiple decades, um, that, that have been underappreciated by, um, the market, by government. And, uh, certainly by, by essential banks. Those productivity gains have essentially increased the output potential for, uh, economies around the world, particularly more in the developed side, the developed economies around the world. Um, so output potential and full employment has actually increased dramatically. And what lacked, um, has been the financial resource to, to create impetus for these economist to achieve those, uh, full potentials. If, if we step back, if you look at, um, maybe five or six decades when we had significant problems with inflation, that was because the output gap was, uh, bridged very quickly when the productivity gains were not as strong. And so back then, if, if governments or, or rather, uh, central banks printed money, it was very easy to kind of bridge the output gap and, and create an inflationary environment that has changed. So we, we've seen almost a couple of decades of declining interest rates before we even got to the negative rates environment. We've seen decades of declining interest rates, essentially printing a lot of money and not creating inflation. A second, second, structural, structural, um, um, factor in, uh, for, for negative rates has been demographics. In the developed world, uh, we've had, um, an aging population that had significant demands, aging and wealthy population that's had significant demand for yield. Um, as, as such, the demand for yield has driven yields down just like any other industry. Wheres, uh, where demanding, um, exceeds supply, you put pressure on, um, on that particular, um, item. So, so that has also created pressure on yields. And so we, we have, so structurally, uh, over decades, we've had a large amount of money being printed, pushing yields down, and then large amount of, uh, demand for, for that, uh, money supply that's also pushed, uh, yields down. Now, fast forward to about a decade ago, we had a financial crisis, and this is where I'm going into kind of the cyclical, uh, reasons for, for negative rates. We had a financial crisis, and a lot of the governments, um, in, in the developed world had already been stimulating economists through cycles, through, uh, fiscal measures. And so by the time we got to the financial crisis, um, a lot of these governments were tapped out from a fiscal perspective. Um, so what we ended up doing was, um, we emphasized, again, to monitor stimulus. And so the, the US government was clearly first with a tarp, but then we had the European financial crisis, and we had developments in Asia where significant amounts of cash was printed. Now, put that in the backdrop of the cyclical, um, developments that I mentioned earlier. We printed large amounts of money and we could not create inflation even though we tried to create inflation, that that was not happening. So governments and central banks were emboldened to continue to do that and push the yields very low, close to zero. On top of that, we've had the European economy since the World War II really has been very much dependent on exports. I mean, Germany is a good case in point, but really most of the European countries have been doing that. Um, and then Japan certainly, um, and later on other parts of Asia have become very dependent on exports. As you depend on exports, you, you want your currency to be lower, and in order to, um, drive that, uh, outcome, central banks have been encouraged to lower yields as well. So the combination of these cyclical and structural, uh, issues kind of set up the environment we are today, uh, where race become negative and the end is not in sight.

Speaker 1:

And, and what, uh, role has central bank buying of bonds played? Because when, you know, Mario Draghi a few years ago said, uh, you know, do anything it takes. And, uh, and they actually just this week, uh, we're recording this in, in around September 12th, the 13th, I guess they, uh, resumed quantitative easing. And part of that is they go out and they buy bonds, and they don't really care what the yield is, they'll just buy it. Right. So what, what role has that played, because that, I think the, the popular perception is it's the primary driver in the short term, uh, has been central bank buying. Is what role do you think that has played?

Speaker 2:

Yeah, clearness. So, so, um, that's a good segue to who's buying, uh, negative yields bonds with negative yields, but also goes to my, uh, um, my point about one of the cyclical drivers for negative rates, um, which is the, the fiscal stimulus points. Now, Europe is not one country, clearly, and the criticism for the European Union has been that they've gone the fiscal, the, the monetary way, but they haven't been able to integrate their fiscal systems. And so, so when we had the great recession in the US and then the subsequent financial crisis in Europe with, you know, countries like the peripheral part of Europe, Italy, uh, Spain and Portugal, certainly, um, Greece, when they had issues where in a kind of integrated economy you would typically address through fiscal stimulus or fiscal transfers from wealthy to, um, um, to, to parts where, um, um, financial resources needed, Europe could not do that because Germany was Germany and the North in general wearing opposition. So that's where the E ECB came in and kind of, um, did the function of fa Fis fiscal transfer essentially, uh, accumulated balances of excess, uh, deposits request excess liquidity from the north was channeled to the south through the central bank, and, uh, by buying government bonds, that transfer went from depositors in the north to governments in the south, essentially. So, so yes, your point is, is right on the, the European Central Bank has played a very important role in the cyclical element of pushing rates negative.

Speaker 1:

And, uh, do you think there's any chance rates would go negative in the us?

Speaker 2:

I think we're very far from that. Um, firstly because again, um, if, if you look at those factors that I mentioned earlier, certainly from a cyclical perspective, the, the pressures on yields exist. We, uh, the output gap is, is very far from breaching. Um, we could put tons of liquidity in the, in the economy and not create inflation. Um, but the cy, the cyclical element, first of all, the US economy is doing very well right now. And yes, there, there are frictions around the, um, trade negotiations with the rest of the world, but regardless, the, the economy is very strong. So, so the need for further the stimulus is, is not evident at this point. That could change clearly, but at this point is not evident. The second point is that if it were evident, the, the US government still has the ability to create fiscal stimulus, and, and so, so where I'm going with this is that negative rates, we, we, we will get to that point a little bit later, but negative rates, um, are not great for the financial system. Um, and to the extent that we're not, we don't have to resort to them, uh, we probably want. And so I believe that the US is not at a point where we have to go negative. Mm-hmm.<affirmative>, can we go? Certainly, but I don't think just yet.

Speaker 1:

Okay. And, and we, we started a moment ago talking about this concept of who buys these bonds. So let's talk a little bit just about the practical aspect of this. So obviously, if a bond is issued with a, a positive coupon and it's issued say at par, but then people bid the price up, you get to the point where the yield to maturity is negative, but it are, are bonds. Obviously, these governments are continuing to issue, you know, longer term bonds over time when they're issued, are they issued with negative yields or are they issued with a positive yield?

Speaker 2:

Yeah, they, they are issued with negative yields right now. Um, I mean, you're right that at outset of the negative freight, um, and, and, and we, we have to, we have to be careful about which rates we're talking about. The short term rates, as we know, are driven by government policy. The long rates, um, are typically driven by the markets. Now, to the extent that the central banks interfere in that markets, then yes, they could drive that as well, which is certainly happening in Europe and in Japan. But the short term rates are really what, what the government controls the, the, the central bank controls. So at the outset of the program, that's the phenomen is exactly as you describe it. A bond might have been, um, issued, um, couple of months ago, uh, with, with a zero coupon or slightly positive coupon. And when the market rates go down, then the, that bond, the value of that bond increases, and the effective yield of the bond on the secondary market goes negative now, but that was years ago. Today, all the bonds that are issued where negative rates persist are with actual negative rates.

Speaker 1:

And so who's buying that? When a government auctions a bond, it says, you know, you're gonna, you're gonna give us a thousand dollars in, in five years, we'll give you 999. Right? Who would

Speaker 2:

Do that? Right. So clearly one of the buyers is, uh, is the acb, right? Uh, in, in Europe and, uh, uh, bank of Japan and in Japan. And those are, those are formidable buyers. Um, as, as you, you might, as you might remember, the ECB is committed to continuing, and, and they, they were kind of scaling down that program, but now seemed to be restarting it. Um, they're committed to stimulating the, the lending within the Eurozone, uh, with, with the cap of purchasing no more than 33% of the particular issue, which means that you know, of, of particular country. So they're not gonna buy more than 33% of Italian bonds or, or, um, German BA bonds, but they certainly have plenty of room left. And so they're, they're formidable buyers on the secondary market. They're not stimulating, um, government purchases directly, but indirectly they are on the secondary market. The second important, um, cohort of purchasers is the so-called, uh, participants in the, in the basis swap, uh, trades. Um, so what, what is a basis swap? It, it typically is a foreign currency buyer of a foreign bonds in order to fill a liquidity gap. Uh, more specifically, imagine you are a multinational Japanese bank that, um, has multinational clients around the world. That bank lends to in US dollars. Now, the, the funding for that bank is predominantly in Japanese. Yeah. So because it's difficult for the bank to source dollars in, uh, in deposits and dollars, um, what they do is they swap their deposits in yen into US dollars. Now, in the process of doing that, the demand for US dollars increases and they get the, the, the, the swap transaction. The, the hedging transaction is, is really that, uh, basis swap where, uh, they drive the demand for, um, foreign currency, particularly for dollars. These transactions are collateralized. And which means that as the swap is affected, the, the notion of amount is actually invested in foreign securities. Mm-hmm.<affirmative>. Um, so within that transaction, the, the US counterparty would actually purchase negative freight, Japanese bonds, government bonds. Similarly, the transaction is done between a European, uh, counterparty and a US counterparty. The, the same dynamic would persist where the, the foreign entity would, um, get US dollars and sell a European bonds, government bonds to the US entity. Now, because obviously your question would be, but why would the US entity engage in a, in a, in a situation where they would get negative rates? And the answer is that because this transaction is typically driven by the demand of the foreign entity for US dollars, then the basis swap or, or the amount that the foreign entity has to pay the US entity to source that liquidity is more than offsetting the negative yield. Mm-hmm.<affirmative>. And so in that transaction, the foreign entity pays US treasury yield plus the basis swap, plus the negative rate. Mm-hmm.<affirmative>. So this is a, a feasible transaction driven by the need of foreign entities to source US liquidity.

Speaker 1:

Hmm.

Speaker 2:

The third in formidable buyer of, of negative, uh, rate bonds is, um, are pension funds and life insurance companies. Now for pension funds, when you have very long-term liabilities, we're talking 20, 30 year liabilities because some of the participants in these pension funds are employees in their thirties and and forties. So they, they have a long way until, uh, they need to withdraw that cash back. And there's really no choice. If you need to have long-term liabilities, you, you have to buy government securities and they try to make up for the cost of that, cuz cuz they're not getting paid for it. You, you would say, well why would you buy it? Well, because cash is not an option. You have to own securities and through different swaps they try to minimize the, uh, the impact of the negative rates. But at the end of the day, what's more important for them is to match the liability and uh, and assets, um, rather than worry about the near term impact from the negative rates.

Speaker 1:

Right. When you say quote cash is not an option, of course we tend over the years we've tended to think in our minds of, of cash as really being sort of short term government securities. But if those have a negative yield, right, you're only alternative is is literal cash currency holding physical currency and that's just impractical. If you've gotta hold billions and billions of, of euros or yen or whatever, you know, you can't have that sitting around. There's storage costs that would, that would sort of carry a negative yield too, cuz you've gotta literally pay for vaults to keep all that cash. That's exactly right. So, uh, yeah,

Speaker 2:

Cash, cash is not free, but also there's a lot of element to that. Um, accounting rules require accounting and capital rules really, cuz these pension funds have to be funded and capitalized and, and those require a matching of assets and liability duration because when interest rates move, you could have significant impacts on, on, uh, the asset liability, um, matching situation if you're holding a short term security like cash versus a long term liability. So that's another reason. And then for life insurance companies, the dynamics are very similar, although they have even additional restrictions in terms of, um, the type of risk that they could take. So

Speaker 1:

One of the other phrases besides whatever it takes that has come to prominence in the last decade is the, you know, Tina, there is no alternative, you know, t i n a and um, the idea was that by keeping rates so low or now even pushing them negative, they're gonna force people with capital to move it into higher risk, uh, investments. But the idea if you make this capital more available, more easily available to companies, whatever, that it would, it would stimulate economic growth. But it's not clear that that has really worked. Uh, you know, we, um, we've had the second quarter, so a negative GDP growth, you know, Q1 Q in, um, uh, in Germany and, and the UK actually as well. So anyways, it's not clear that this policy has really worked and I wonder if central banks are, what their thoughts are on this and are they gonna reconsider this? Um, but I, I dunno if you have any thoughts on that. I

Speaker 2:

I absolutely agree with you that, that the stimulating part of this equation is just not there. We have significant amounts of liquidity, um, at, at, uh, on corporate balance sheets. And, um, just because rates are even zero, let alone negative, does that mean if, if they don't need to invest in capital or if their working capital needs are perfectly met, they don't need more debt. And it doesn't matter if it's minus five for minus 10% Right. They just don't need it. Right.

Speaker 1:

This is where we get the expression pushing on a string.

Speaker 2:

Exactly. But again, going, going back to my original points about how we got here currently negative rates are maintaining, um, a foreign exchange balance that is satisfactory to, to Europe and, and Japan cuz otherwise their currencies, what would've been different. And so there's, there is economic stimulus through lowering their currencies. Right. That's the only benefit that I could see at this point.

Speaker 1:

Well, you could say something else

Speaker 2:

About that. Yeah, so I was gonna say the la the last, uh, and, and this is the most unlikely, um, unexpected purchaser of, uh, negative rate bonds of size is really index funds. And, and this is, this is unfortunate, but this is inertia, um, because a lot of, like I said, baby boomers or, um, not, not necessarily only through pension, uh, programs like defined contribution or uh, or defined benefits. People go out there and buy, um, bond index funds and they don't realize that a good portion of that index fund is invested in government securities. Mm-hmm.<affirmative> and those securities are actually yielding negative rates. But because this is typically the aggregate type of fixed income securities funds, they also have corporate debt in the mortgages and other things that actually have positive yields because they have spread and the overall yield of the fund is positive, which masks the fact Right. That it actually holds significant amounts of negative rate bonds in it. Right. Right. So that's the kind of unfortunate purchaser

Speaker 1:

Right. Plays right into, uh, the limits of theory paper that we talked about in a previous uh, podcast where just cuz something's in an index is not a reason to own it from an investment perspective. That's right. Okay. So let's, um, let's finish up with some discussion on banks. Yeah. And what does the, what do negative yields mean for banks? Cuz the traditional view is, you know, banks borrow short, they've lend long, well if long rates or so low, how do they make any money?

Speaker 2:

So yeah, so, so you hit the nail on, on, um, uh, on the head. Certainly negative rates are not good for the financial system, not just for banks, but for our think about insurers, think about all entities involved, uh, because that distorts the cost of money and this is what the financial system does. It, it, um, um, it tries to determine that and distribute, uh, financial assets based on their cost. So that distorts everything. Now, banks are in the center of that and the traditional view has been that banks, um, borrow short, namely get short term deposits and lend long namely, um, longer term loans like, uh, mortgage loans and car loans or corporate loans that have maturities and durations of in excess of five to 10 years. So, but I, I would say that there's a bit of a misconception in that because when interest rates are high, banks can do that. When, when interest rates in the economy are in an four to 5% range, um, banks can afford to pay two to 3% for deposits. Um, and then, um, have a, have a mortgage spread that's beyond the risk cost of that mortgage. Um, and therefore make money just because of the duration mismatch. However, when interest rates are very low and which has been the case even prior to becoming negative, they, they were very low for quite a bit of time. Um, that game, so to speak, is, um, does not work. Banks no longer do, they haven't been doing that for over a decade now, it's important to emphasize what banks are, they truly are asset managers. They take resources from, um, depositors and they invest these into loans. And as they do that, um, their sole purpose is to do a proper underwriting, which would ensure that most of these resources that are lent out will come back so they could just, so they could return the money back to the depositors. And we have regulators, uh, central banks, um, F D I C type of, um, uh, agencies that ensure that banks are in, in fact doing exactly that. They're, they're, uh, lending responsibly. And so as such, um, banks charge and an interest rate spread, that covers the risk for the, uh, borrowers not paying, um, the, the so-called credit risk. And so this is regardless of the funding cost. So if, if the deposits cost to the bank, zero 1%, 4%, or negative 50 basis points, that spread the bank's charge on top of that is what determines bank's profitability theoretically. Um, and that has actually been the case in reality as well. If you look at the Danish banking system, which, um, like I said, Denmark was the first country to, um, I implement negative rates in 2012. For the last seven years, Danish banks have been profitable. And if you look at their net interest margin, which is the difference between what they pay for resources for financial resource and, and what they gain from lending that or buying securities, it's been 1% very persistent rates had, uh, been moving up and down the funding rates and their, their spread has been about 1%. So from that perspective, um, banks have been, um, helped by going back to their roots. Um, however, um, the, the, the longer term impacts are real. Um, and what I mean by that is, um, in addition to lending, banks also have security portfolios. And those security portfolios to a large extent have government bonds in them. And the duration of these bonds is relatively long. Um, and, and the lower the rates, the longer that duration happens to be because they kind of go out on the curve and as they roll those, they reinvest them at much lower yields. And in Denmark, that's already, um, uh, obvious in, in Europe it's less so because they still have bonds that are, that are, when they were issued, they hold them to maturity. So the market movements are less relevant, but these bonds are still yielding positive rates and as they mature, they have to reinvest them at a lower rate. So that puts pressure on profitability because there's no credit spread per se, as, as the one that I described for the loan portfolios.

Speaker 1:

So the longer this goes on, actually, it might start to become troublesome for the

Speaker 2:

Banks. Well, it, it, it has been trouble. So in terms of it's been lowering their profitability, right. Um, and it will continue to do so now there's gonna be a point, and I think Japan's reached that point, um, where the profitability is just gonna be limited to the credit spread. And of course, the, the good news is that when rates are so low, the credit environment happens to be pretty good, just fewer and fewer companies default. Mm-hmm.<affirmative>, that's not to say that we, we cannot get into a recessionary environment with negative rates, which would be problematic because at that point you have very low spreads for credit. Um, and if you have a a credit situation, then banks profitability is gonna be compromised. Right. So you are absolutely right that the longer this goes, the more problematic it will become, but it's not an, an immediate death to banks. As, as, again, the, the Danish example is very good. Seven years into that, Danish banks is still quite profitable. Their return on equity is close to 10%. Mm-hmm.<affirmative>, so, you know what, what I would conclude, uh, as far as banks are concerned is that it, it really depends on the banking structure, the banking industry structure. So if, if the banks, so in the United States, for example, we have about 6,000 banks, and you would think that the, the competition would be very fierce, but, and it is, however, it's not unreasonable. Banks are competing with each other, but they're not going below the level of profitability that would ensure their solvency and liquidity for the long term. Of course, that's helped because the regulators is making sure that's the case, but also the owners of bank capital, which is US shareholders, make sure that, uh, they behave and they do. In Japan, for example, it's a slightly different story where banks, and that's very similar in Germany by the way, where banks, um, um, are doing a social service. Essentially, they, they are helping corporates thrive. And, and so regardless of cost and profitability, banks are, are out there to provide credit. And so they compete to the point where their profitability is very, very low. And if you talk to Japanese, um, Japanese bank management teams, very often they'll tell you that what the environment is very good for credit. We don't have to worry about that. So lower profitability is okay. Mm-hmm.<affirmative>, and I disagree with that because obviously when the cycle hits, which it always does, right, that dynamic will be

Speaker 1:

Different. Right. It's a view of banks almost as public utilities. Exactly. Yeah. Okay, well I think we'll wrap it up there. It's been really been very interesting. Learned a lot. Uh, again, my guest has been Nick Petrak, financials analyst here at Epic. Thanks for tuning in and we'll talk to you again soon. Remember to subscribe to actively speaking on Apple Podcast, Spotify, or Google Play. You can find all of our previous episodes and additional content on our website, www.eipny.com.

Speaker 3:

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Speaker 4:

Stop audio.