“Conjuring Profits From Sub-Zero Yields”

 The above is the title of the recent Bloomberg article that discusses the ECB’s penalty rate on bank excess reserves (which as one analyst recently remarked have become the proverbial “hot potato” now that a 20 bp fine is charged for their possession) and its effects on bond markets. In euro-land, government bond yields have already completely collapsed, partly to almost Japan-like levels – and yet, more capital gains can still be achieved, even with paper sporting negative yields. According to the article:


“David Tan got to help oversee $1.5 trillion at JPMorgan Asset Management by picking winning trades. Now he’s studying how to make money from investments that look sure to lose.

Across much of Europe in the past year, the yield on two-year government debt tumbled from little, to none, and then below zero. That means buyers would walk away with less cash when the securities matured — if they waited that long.

Money managers like Tan are navigating a market where positive returns are still possible on debt with negative yields provided others will pay a higher price before the notes come due. Those opportunities were enhanced last week when the European Central Bank increased the cost for financial institutions to park their money with it. After that, depositors were tempted to take their cash from the ECB and funnel it intogovernment bonds, because the negative yields hurt less than the central bank’s more punitive charge.

“If yields continue deeper and deeper into negative territory, the opportunities for capital gains remain,” Tan, who is head of rates in London for the fund-management unit of the U.S.’s biggest bank. “If your central hypothesis is that yields are going to converge” with the ECB’s charge on deposits then you still see “some potential price appreciation,” he said.

The list of institutions that may choose to lose includes asset managers so large they’re willing to pay for their cash to be held safely as well as banks that want to avoid the higher ECB charges. And it includes many large financial groups like insurers whose rules are too inflexible to give many alternatives. At the top of the heap probably are other central banks.

Central bankers “are a fairly value-insensitive bunch,” Michael Riddell, a London-based fund manager at M&G Group Plc, which oversees the equivalent of about $415 billion, said on Sept. 5. “They have to invest their FX reserves somewhere if they want to buy euro-area assets that have the top credit ratings, then they have no choice.”


(emphasis added)

We have previously remarked that some of the buyers of short term government debt with a negative yield are those who don’t trust the banking system with their cash. This actually makes at least some sense. All the rest only shows how utterly crazy the market distortions caused by central bank policies have become. Why the geniuses running the central banks believe that this time, this is somehow going to end well, is utterly beyond us.


1-Germany, 2yr yieldGermany’s 2 year note yield – deeper into negative territory, at minus 0.055% – click to enlarge.


Such negative yields can only exist in the policy-distorted world – the natural rate of interest can never turn negative, as that would imply that future goods can be worth more than present goods. This is a logical impossibility. Note here that the natural interest rate is nothing but the price ratio between future and present goods. It is actually a non-monetary phenomenon, expressing time preferences, which can be low, but are always positive. If they were at zero or negative, people would stop consuming altogether and would soon starve to death.

An inference from this is that current central bank policies are once again leading to capital malinvestment and capital consumption on a large scale. This is also demonstrated by the asset bubbles currently in train. E.g. stocks are titles to capital and thus reflect the mispricing of capital and partly illusory profits that stem from misguided economic calculation.


Covered Bonds in the Grip of ECB Madness

Since the ECB has announced it will engage in outright purchases of covered bonds, i.e., it will buy these assets with money conjured from thin air, the covered bond market has been infected with crazy behavior as well. The ECB is not the only central bank in the market – others from that “value-insensitive bunch” are apparently active as well. Here is a summary of the salient points from a report on new covered bond issues in France in recent days – for more details see here (note though that this site requires registration):


“CFF priced EUR 1bn obligations foncieres at 5 bps through mid swaps this morning. The EUR 1 b. offer generated bids for EUR 4.8 bn. from 150 accounts, with heavy central bank participation. Comment of a syndicate official:

“The plus 1 bp area and even the minus 2 bp area guidance turned out to be quite conservative”  Further: “It’s quite a jump, I have to admit. Syndicates and issuers are getting used to this post-ECB world, with the market bid only and so technical. It’s crazy”

Caffil’s 1.25 bn. issue from Monday (which generated 4.9 bn. in bids) had already tightened from its reoffer of 1 bp through to -5 bp to -8 bp by Tuesday morning.

“Everyone’s piling in”, said the syndicate official, although he noted that accounts that were finding pricing too tight were biased towards bank treasuries. “It’s difficult for it to make sense for them”.

A syndicate banker away from the leads said that CFF’s results were “astounding”.

“That’s a trade! It just goes to show how crazy things are. People expect spreads just to ramp in on the back of this purchase program (referring to the ECB here). But there’s got to come a point where you have to ask if investors know what they are buying and what they are doing.”

“Things are so tight, I get a headache just thinking about it” said a banker away from the deal. He noted that a EUR 500 m. UniCredit Bank Austria benchmark issued on April at 23 bps above mid swaps now trades at around 7 bp over.”


(emphasis added)

We can only agree: it is crazy. It “works” only as long faith in the omnipotence of central banks remains intact. This faith will eventually be tested. Note here that the underlying assumption is always that the monetization of assets is just a temporary policy instituted to “help the economy”. The latter is absurd, the former remains to be seen. So far all these “temporary” interventions undertaken since 2008 seem to just continue, with more piled on every year (whereby major central banks seem to be alternating in the printing duties).

In other words, it is by no means guaranteed that the beliefs currently held by market participants are immutable. Let us for argument’s sake say though that these central bank interventions will not only cease, but will be significantly reversed at some point. What then about all those assets that have been bought at paltry or even negative yields? What about the mountain of interest rate derivatives that have been written and are supposed to hedge these positions?

It seems to us that central banks have embarked on a one-way street. Unless they are prepared to preside over a monumental bursting of the asset bubble, they are in a box. Hence the widespread faith in the temporary nature of central bank money printing is likely misplaced. It won’t stop until the markets revolt.

One market that needs to be closely watched in this context is the JGB market (or what is left of it), as Japan is the nation where extremely low bond yields, massive debt monetization and huge public debt growth all have a considerable head start. It seems quite possible that faith will crumble there first. Should that happen, it will crumble everywhere. Once again, the chart of JGB yields actually reminds us of how gold looked when it bottomed in 1999-2000. The similarity is in fact eerie.


2-JGB yieldJGB yields – finally bottoming out? – click to enlarge.


For comparison, below is a line chart of gold from mid 1997 to mid 2001. We will see whether the JGB market will continue to track it. There is of course no reason for this to happen apart from the fact that chart patterns of different markets often tend to look similar at key junctures.



3-Gold, 1997-2001Gold from 1997 to 2001 – a pattern eerily similar to that in JGB yields – click to enlarge.



Central bank interventions always “seem” to work up to a point. As long as enough real wealth is created that it is possible to divert some of it toward bubble activities, everything appears to be fine. However, major structural economic distortions and asset bubbles are invariably the result. The question is usually only whether the interventions are discontinued voluntarily or not. In either case an economic and market backlash is unavoidable. If an inflationary policy is not abandoned, it will eventually end up destroying the underlying monetary system. If it is abandoned in time, all the malinvestments are unmasked and a major bust becomes unavoidable. Apparently central bankers like to be between a rock and a hard place. That wouldn’t be a problem if not for the fact that everybody else is affected by their actions as well.


Charts by: BigCharts, StockCharts




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12 Responses to “Central Bank Induced Market Distortion Goes Bananas”

  • mc:

    The thought experiment about vikings coming is about paying some costs out of production to retain claim on goods, ie security. “future goods ALWAYS have a discount vs. present goods” or “rate of interest cannot be negative” still holds to be true. If you would trade two stacks of grain now (as vikings come to violate your property rights) for one stack of grain a week later (after the vikings leave/property rights restored) that is no different than paying a grain elevator to store it to prevent spoil and rodent theft during the winter.
    In a negative interest rate scenario, giving two grain stacks and getting back one stack of grain a week later would be worse than getting the same stack a month later, and worse still than a year later, payment in 1000 years is preferable to 1, etc.
    It implies a preference that the debt buyer (lender) prefers delaying repayment indefinitely, something that seems contrary to economic logic. The only entity (lender) that prefers to never be paid back is the central bank holding government debt securities. This is expressed quite clearly by the central bank interventions and fiscal policies that create enormous amounts of unpayable debt and an unsustainable situation.
    A lender buying up everything and handing out money to everyone would seem to be good for a period of time, but eventually the fiction of infinite and free will come up against the reality (economic truth) of finite and scarce.

  • RedQueenRace:

    “Money managers like Tan are navigating a market where positive returns are still possible on debt with negative yields provided others will pay a higher price before the notes come due.”

    “Greater fool” behavior has now come to bond markets.

  • No6:

    Fascinating Gold JGB comparison.

  • Incredulous:

    Quote: “Such negative yields can only exist in the policy-distorted world – the natural rate of interest can never turn negative, as that would imply that future goods can be worth more than present goods.”

    Zerobs–if you can’t store future goods because they don’t exist yet, then you cannot value them, either, because they do not exist yet. So that argument goes nowhere, because if future goods do exist in any sense at all, they exist in that people are willing to put some kind of value on the idea of them. That value could be quite high: “Honey, look at this pile of grain that I have today!” “Yes, sweetheart. Say, is that a Viking longship drawing up on shore, there?” “Gosh, I wish I had that grain next week, not today! I’d pay half of the pile for that privilege!”

    Why isn’t that an example of future goods being worth more than present goods? Serious question, mind you, despite the droll example.

    • RedQueenRace:

      “For comparison, below is a line chart of gold from mid 1997 to mid 2001. We will see whether the JGB market will continue to track it. There is of course no reason for this to happen apart from the fact that chart patterns of different markets often tend to look similar at key junctures.”

      Another reason is that sometimes market participants look to other markets for clues and correlations that really don’t make any sense take place (and become self-reinforcing) until they suddenly just end. In the book “West of Wall Street,” Barry Haigh mentioned there being a time that a silver rally would induce a soybean rally because the grains traders watched silver prices.

      • RedQueenRace:

        I have no idea how the above got posted as a response here.

      • I agree that it may mean absolutely nothing. But it is such an astonishingly similar chart that I had to show the world anyway…:)

        However, there is one additional similarity between these markets that may make the exercise worthwhile beyond noting the similar chart pattern as such. Both markets developed this pattern after going down for such a long time (20, resp. 25 years), that everybody has completely given up on them. What one reads today about JGBs (the famed “widowmakers”) reads exactly like the stuff one could read about gold in 2000. I recall interviews with gold futures traders at the time (“one must simply sell every bounce”) and prominent WS strategists recommending to short the gold stocks in mid 2000, many of which were already down 90-95% from their former highs.
        So you have a very similar psychological setup, and the sequence shown on these charts actually reflects that. Take the big rally off the initial low, which is subsequently given back almost in its entirety (which is incidentally the mirror image of the bull market ending pattern in the S&P 500 in the year 2000).
        It shows that there us such huge disbelief that even technically strong moves off extremely low levels are sold one more time.
        In short, there may actually be something to this pattern similarity in this case….

        • RedQueenRace:

          No disagreement. I wasn’t trying to imply that the correlation is meaningless in this particular case It gave me a chance to tell the silver/soybeans story, which has always amused me.

    • I should perhaps have formulated it a bit differently to make clear why future goods ALWAYS have a discount vs. present goods. It is not the goods as such that are at issue – it is the want satisfaction they provide. I will quote Ludwig von Mises on the topic to save time (besides, he said it all best anyway). Note that Mises uses the term “originary interest”, which is the same as “natural interest”:

      “Originary interest is the ratio of the value assigned to want satisfaction in the immediate future and the value assigned to want satisfaction in remoter periods of the future. It manifests itself in the market economy in the discount of future goods as against present goods. It is a ratio of commodity prices, not a price in itself.
      Originary interest is a category of human action. It is operative in any valuation of external things and can never disappear. If one day the state of affairs were to return which was actual at the close of the first millennium of the Christian era when people believed that the ultimate end of all earthly things mas impending, men would stop providing for future secular wants. The factors of production would in their eyes become useless and worthless. The discount of future goods as against present goods would not vanish. It would, on the contrary, increase beyond all measure. On the other hand, the fading away of originary interest would mean that people do not care at all for want-satisfaction in nearer periods of the future. It would mean that they prefer to an apple available today, tomorrow, in one year or in ten years, two apples available in a thousand or ten thousand years.
      We cannot even think of a world in which originary interest would not exist as an inexorable element in every kind of action. Whether there is or is not division of labor and social cooperation and whether society is organized on the basis of private or of public control of the means of production, originary interest is always present. In a socialist commonwealth its role would not differ from that in the market economy.”

      I hope this explains the issue….

      • Keith Weiner:

        In gold, no saver will lend unless he gets a rate of interest >= his time preference. However, in irredeemable paper money, the time preference of the saver is rendered irrelevant. Savers are disenfranchised. Their values are simply not a consideration in setting the interest rate.

        The rate of interest is totally unhinged. It can shoot the moon as it did after WWII through 1981, or it can collapse into the black hole of zero.

  • pigeon:

    “Such negative yields can only exist in the policy-distorted world – the natural rate of interest can never turn negative, as that would imply that future goods can be worth more than present goods. This is a logical impossibility”.

    I’m not sure if that is correct. If the future goods have the benefit to be certainly available at that time, it might be reasonable to pay for their safe storage. If the security of bank deposits or other means of storing wealth currently appears to be compromised but faith in the ability of a government to honor its obligations in the future (e.g. 2 years from now) is maintained, then the negative yield is just an insurance premium.

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