How low can you go? Deflation and negative bond rates

How low can you go? Deflation and negative bond rates

With everyone getting very hot under the collar or excited (depending on whether you are a borrower or a lender) about the prospect of Australia’s cash rate falling below two per cent, we thought it might be interesting to point to something even more interesting that transpired last week in Europe.

As the ECB (European Central Bank) reduces borrowing costs through its €60 billionn-per-month Quantitative Easing program, already low yields are turning negative!

Last week Nestle’s four-year, euro-denominated bond traded at negative 0.008 per cent.

Now, it’s easy to jump to the conclusion that investors are effectively paying to have their money in bonds. But consider the following; in a deflationary environment cash is the safest asset class because the value of a single dollar – even if parked under the bed – actually increases over time. If you believe that deflation is a real risk, then owning bonds is akin to being a lender, and regular fixed amounts of cash income becomes very attractive.

Last week’s move in Nestle’s bonds is not unique. Last year no European bonds with over a year to maturity were trading at negative yields. Today there is more than €1.5 trillion according to reports by JP Morgan. There must be a large number of people betting on deflation.

Denmark debt now has negative yields on bonds with maturities out to six years, as does Germany, whose ten-year bonds are trading at just 0.34 per cent. Swiss ten years are at -0.20 per cent and Austria, Sweden and The Netherlands are also offering negative rates out to five years.

Perhaps most interesting is the following example of two regions with similar conditions but entirely different sentiment by investors towards those conditions. In Europe UBS’s credit analyst Thibault Colle was quoted as saying: “The ECB is in easing mode and that’s a great place for fixed income rather than equities because the growth story for earnings simply isn’t there.”

Interestingly, Australia might be described as being in the same place with respect to an easing bias by the central bank and low earnings growth (thanks to China), and yet the conclusion here is that the high relative yields makes equities the right place to be.

Australian cash rates are now at 2.25 per cent. The market however now expects rates to fall further and this can be seen in the table of bond yields out to five years.

With all bonds with maturities up to five years trading at yields lower than the current cash rate, commentators have pounced, suggesting the RBA is “behind the curve”. It might be true that the RBA does not agree with the market, but it is not always the case that the market is right. Indeed future yield curves are almost always wrong over three and ten years.

Roger Montgomery is the founder and Chief Investment Officer of Montgomery Investment Management. To invest with Montgomery, find out more.

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Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

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