Has Draghi Destroyed The European Bond Market?
The European Central Bank's policies of negative benchmark interest rates in addition to a massive bond buying program have distorted the European Union's fixed asset market to the point of failure. Some government bond yields are so far into the negative, that the ECB itself is prohibited from buying them.
The results of these logic-defying monetary policy measures are harming, rather than helping, the economies of the European Union.
Fundamentals Have Been Destroyed
Bonds are no longer bought on the fundamentals of return versus risk. Instead, investors are buying them with an eye to reselling them later at a profit. Conversely, some of the most active sectors in the stock market are those that pay high dividends.
“Investors are buying bonds for capital appreciation and stocks for income. The world has turned upside down,” said James Abate, chief investment officer at Centre Asset Management LLC. A rough survey by Jefferies’ global equity-strategy team showed that at least one-third of S&P 500 stocks offer dividends higher than the same company’s bond yield.
This "altered investment reality" is possible only because central banks are doubling down on theory-driven policies that simply are not working. For example, the European Central Bank has set its benchmark deposit rate at -0.4%, forcing banks to pay the ECB for the privilege of holding their money, or finding other places to store it. The ECB's idea was to force banks to lend out more money, but the reality is, negative rates have constricted bank profits at a time when the ECB demands banks keep more liquid assets on hand, which reduces lending.
In addition to the disruption of negative rates, the ECB has expanded its monthly quantitative easing purchases to €80 billion of bonds every month. The result of 16 months of hoovering debt from the Eurozone marketplace has been negative government bond yields for the first time in history. The demand for sovereign debt has grown so great, even 10-year bonds are selling at a negative yield on the marketplace.
The situation has gotten so out of hand, that one-third of EU government debt, and more than 50% of German debt now have yields under -0.4% (the ECB's benchmark deposit rate.) This means those billions of euros worth of government bonds are now ineligible for purchase by the ECB.
(Epizentrum (Own work) [CC BY-SA 3.0], via Wikimedia Commons)
Never one to let market realities stop him, ECB President Mario Draghi simply widened his net. The European Central Bank began buying corporate debt in Mid-June. The lucky 150 corporations on Draghi's list began shoveling out new debt offerings, knowing that they had a compulsory buyer. In fact, the European Central Bank purchased more than €10.4 billion of corporate bonds in the first six weeks of the program. This has driven 24% of the European investment-grade bond market into negative yields. The average yield on €36 billion of short-term euro-denominated corporate debt is now -0.08%.
It's monetary policy, Jim, but not as we know it.
Draining The Liquidity Pool
Not only is the European Central Bank a victim of its own bond-buying program, but institutional and retail investors have been sucked down the liquidity drain as well. London fixed-income trader Paul Suter told Bloomberg, “The ECB is sucking a decent portion of bonds out of the market on a daily basis. Liquidity was already challenging, but this buying program is now the massive gorilla in the room and has exacerbated the situation.” The ECB may increase its liquidity by decree. Rumors are circulating the Draghi will introduce the idea of just "moving the line in the sand," and allow the ECB to buy bonds with yields deeper in negative territory.
In another in the long list of unintended consequences, bond traders are being squeezed by ECB QE as well. The illiquid status of the market means it is more difficult to fill bond orders. This difficulty means that trading fees have increased. For every €1 million of bonds purchased, a buy will be €6,200 in fees. This is about 35% higher than it was last year. If you want to buy junk bonds, be prepared to fork over €13,000 in fees, 32% more than last year.
Negative Out The Gate
While negative government bond yields on 10-year notes have become commonplace, this is a yield that is determined by the secondary market.
Not any more.
This month, Germany became the first nation in the EU to auction ten-year bonds at a negative yield. Some market watchers wonder what took them so long. The auction of €4.8 billion of German 10-year bonds were sold at a yield of -0.05%. Germany wasn't the first nation to auction long bonds at negative yields. Japan did so in March. but Switzerland was first. Switzerland is an old hand at putting negative-yield bonds on the auction block. Not only did they issued 10-year notes with a negative yield, they sold 42-year bonds at a yield of -0.02% last week.
Not Just For Governments Anymore
Perhaps the biggest red flag on Europe's trip down the rabbit hole is news that a German railroad has successfully issued a five-year bond at a negative yield. Deutsch Bahn is the first non-bank EU company to issue negative yield debt, though some point to the fact that it is 100% government-owned as a reason not to call this bond "corporate debt."
Banks have been issuing negative interest debt since March, when German bank Berlin Hyp became the first to cross that line. Recently, Deutsche Hypothekenbank's negative yield venture was five times oversubscribed, meaning there was demand for 5x the amount of bonds being issued.
The Canadian Imperial Bank of Commerce recently became the first non-EU entity to issue a euro-denominated bond at a negative yield. The mortgage-backed €1.25 billion issue was sold at a rate of -0.009%, and was two times oversubscribed.
“Berlin Hyp was the first but issuers were still quite reluctant to issue at negative yields,” said Joost Beaumont, analyst at ABN Amro. “This shows that this reluctance was a bit overdone – investors are more than willing to buy it.”
What Could Go Wrong?(Plenty)
Let's just go over some of the things that are going/could go wrong:
- Negative interest rates are squeezing banks to the point that they may be susceptible to failure in the next financial crisis.
- At the same time, new banking regulations forbid them to trade in the bond market to the extent they did before, worsening the crisis in liquidity in bonds.
- Pushing interest rates deeper into negative territory will force banks to start passing the costs on to their customers. This will lead to deposits being withdrawn, reducing the amount of money available to lend.
- Investors are not buying stocks for a return. They are buying them with a short-range goal of "flipping" them for a profit.
- Savers and institutions like insurance companies and pension funds have had their main source of assets taken away from them, driving them into riskier assets.
- Bonds no longer provide a hedge against stocks.
- Negative interest rates encourage governments to spend profligately.
- Negative yields push investors overseas to find a profit, reducing activity in the EU.
- The ECB has trapped itself into being forced to continue QE. An EU "taper tantrum" could unleash an unparalleled financial shock to the Common Market.
- Conversely, if the ECB continues its bond purchases, the liquidity crisis in the bond market will only get worse.
You probably know one that I have missed. Let me know in the comments.
The opinions and forecasts herein are provided solely for informational purposes, and should not be used or construed as an offer, solicitation, or recommendation to buy or sell any product
A published writer, Steven's coverage of precious metals goes beyond the daily news to explain how ancillary factors affect the market.
Steven specializes in market analysis with an emphasis on stocks, corporate bonds, and government debt.