The Madness of Negative Bond Yields

As we have frequently discussed in these pages, time preference must always be positive on a society-wide basis – it is a praxeological law that future goods and/or satisfactions are valued at a discount to identical present goods. We emphasize “identical” here because sometimes people are asserting that there are exceptions, such as in the famous example that men would prefer having ice in the summer over having it in the winter (thus, in wintertime, ice available in the future would be valued more highly). However, “summer ice” is not identical to “winter ice”, even though it has the same physical properties. The reason is that the satisfaction if provides is not the same.

 

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As an aside, this also explains why the assertion that the prices of goods will tend to equalize across the entire market economy (excl. transportation and other extraneous costs) is not disproved by the fact that a cup of coffee in Hicksville can be bought at a lower price than e.g. an identical cup of coffee offered by the Sacher coffee house next to the opera house of Vienna. In spite of the physical properties of the two cups of coffee being the same, they are not the same good. In the latter case one pays a premium for the view of the opera house and the general atmosphere of the location.

 

1-Germany, 2 year noteGermany’s two year note has a current yield to maturity minus 27 basis points. The centrally planned monetary system is careening out of control and producing unprecedented distortions in financial markets – click to enlarge.

 

As a result of this, the so-called natural interest rate can never be negative, but the same can obviously not be said of gross market interest rates. As a reminder, the latter include a price premium (which reflects inflation expectations) and a risk premium (which reflects an assessment of the borrower’s creditworthiness). So what can be said about the negative yields to maturity currently prevailing on many European government bonds?

Most importantly, it should be clear that such negative gross market rates would not come into being in an unhampered free market. Central bank intervention in bond markets is an important driver, as the ECB is e.g. prepared to purchase sovereign bonds up to a negative yield of minus 20 basis points. Another non-market driver are EU regulations concerning bank capital and the risk weighting of assets: government bonds have a risk weighting of zero (i.e., they are considered “risk free”, which is of course an utterly absurd legal fiction), so banks have a strong incentive to hold these bonds irrespective of their yields. Also, banks need to hold “high quality” collateral for repo transactions, and they pay a 20 basis point penalty reserves held on deposit with the ECB. All these technicalities play into the decision to hold government bonds with negative yields.

However, one could well argue that a negative price premium is in the realm of the possible. If a bond maturing in two years time yields a negative 20 basis points and investors expect future “price inflation” to clock in at a negative 50 basis points, they are still making a profit of 30 basis points in real terms if they hold the bond to maturity. It would of course be even better to simply hold cash currency: the real gain would be 50 basis points, and the financial risk incurred would actually be slightly lower. However, if one needs to invest 100ds of millions, holding such a vast amount of physical cash requires vaulting services and involves insurance costs, while enacting transfers and payments becomes relatively complicated. Many large investors therefore see negative yields on bonds in as a fee they incur for the convenience of holding bonds rather than large amounts of cash currency.

However, another very important driver of negative government bond yields in Europe is undoubtedly distrust of the banking system, combined with the realization that the era of tax-payer bail-outs of banks is drawing to a close. From January 2016 onward, the EU’s Bank Recovery and Resolution Directive will become law all over the EU. Every large depositor and unsecured creditor to European banks must thereafter expect to be “Cyprused” if a bank gets into serious trouble.

Why should there be distrust though? Hasn’t the ECB’s “rigorous stress test” just confirmed that almost all systemically important European banks are in fine fettle and will survive even a deep economic crisis? 25 banks failed the stress test, but their combined capital shortfall was less than €25 billion, not taking into account capital that has been raised after the cut-off date. Including these capital raising measures, the total shortfall amounted to less than €10 billion, with a few outliers such as Italy’s Banca Monte Dei Paschi di Siena accounting for the biggest share thereof.

 

2-stress-testsAn overview of the ECB’s stress test results, not taking into account capital raised after the cut-off date – click to enlarge.

 

So there is no problem, right?

 

Austria Ends Government Deposit Insurance – Honni Soit Qui Mal Y Pense

Austria has become the first euro area member nation to suspend government insurance of bank deposits completely as of July of this year. Hitherto, small savers and depositors could rely on the government protecting all deposits up to an amount of €100,000. The banks have a few years to build up a deposit insurance fund of their own, which even once it is fully funded will amount to a ridiculously small percentage of the deposits it is supposed to insure. By 2024 the fund will be large enough to insure precisely 0.8% of all bank deposits in existence at present. However, by 2024 deposit money in the system will likely have increased, so by the time the fund is built up to its total intended size, it will de facto insure an even smaller percentage of deposits. In practical terms, this means that only small demand and savings deposits deposits at the smallest of banks can be considered safely insured. If one of Austria’s bigger banking groups should keel over at some point in the future (such as Erste Group, Raiffeisen or Bank Austria), the deposit insurance fund cannot possibly guarantee that depositors will be made whole.

In principle, it is of course good thing to end government-sponsored deposit insurance. Deposit insurance has been a facilitator of recklessness in the fractionally reserved banking system, as depositors aren’t sufficiently concerned about the system’s inherent risks. However, the problem is that the average citizen is simply unable to determine whether a modern-day fractionally reserved bank is actually healthy or not. In fact, bank balance sheets are in many ways so opaque that not even well-versed analysts are truly able to judge a bank’s health and ability to withstand crisis situations.

The 2008 mortgage credit crisis is testament to this fact: shortly before the crisis broke out in full force, assorted experts almost to man declared the US banking system to be in ruddy health. Shortly thereafter virtually every major bank had to be bailed out. Official “bank stress tests” are little more than propaganda exercises designed to shore up confidence. An honest stress test would have to acknowledge that all banks are de facto unable to pay even a relatively small percentage of their outstanding demand liabilities on demand.

There is something that makes this recent move by Austria’s government very interesting.  Austria was one of the three countries that adopted the EU’s new ‘bail-in’ regime (the above mentioned Bank Recovery and Resolution Directive) as national law one year earlier than required by the EU. Shortly thereafter, it suddenly turned out that Heta Asset Resolution (the “bad bank” housing the assets of the defunct Hypo Alpe Adria Bank – HAA) is in fact unable to pay its creditors, in spite of countless of billions in bail-out funds that the government has already provided to it (see: “Wiener Blut” for details on this).

The problem is that the Austrian province of Carinthia has issued guarantees to HAA’s creditors to the tune of €10.8 billion (five times the province’s total annual budget). However, these deficiency guarantees have a unique feature: they are sureties according to the Austrian civil code, and only become activated once the entity issuing the bonds actually files for bankruptcy. The bail-in directive allowed the financial market supervisor to simply declare a debt moratorium and thus avert Heta’s bankruptcy. Creditors with “guarantees” can essentially use their guaranteed bonds as wallpaper now (or kindling if they have a wood stove). Senior creditors may get some of their money back (up to 50% according to rumors), but subordinated creditors – even if their bonds are “guaranteed” – will likely be wiped out completely. Even if a bankruptcy is eventually declared and creditors win all the law suits they have launched against the government, they will still be faced with the fact that the province issuing the guarantees will be bankrupt and unable to pay as well.

All of this makes the government’s sudden urge to quickly end its deposit guarantee a bit suspicious. It seems possible that this is the precursor to even more upheaval in the banking system. Austrian banks are inter alia the non-Swiss banks with the largest amount of outstanding CHF-denominated loans (especially to Eastern European borrowers), and the Swissie has soared against EME (emerging Europe) currencies and the euro after the SNB’s decision to discontinue its minimum exchange rate peg. Recall that one of the things revealed by Heta after its most recent asset review was that it had to write down the value of its outstanding CHF assets by a cool 85%.

Austrian banks are among the biggest Western European players in Eastern European markets, and recently Raiffeisen International Bank (RBI) got into plenty of trouble with its exposure to Russia and Ukraine. When things are going well and a boom is underway in the EME area, they are making a lot of money. When the tide goes out though, they are suddenly faced with huge write-offs and soaring NPL ratios. In fact, the NPL ratios of Austrian banks in Eastern Europe are huge – they stand at well over 20%. This is balanced by low single digit NPL ratios in their domestic business, but it is noteworthy how big NPL ratios still are in Eastern Europe a full seven years after the 2008 crisis.

 

3-ATXThe Vienna Stock Exchange Index ATX remains well below its pre-crisis highs, while e.g. Germany’s DAX has in the meantime attained new all time highs. This is likely reflecting perceptions about Eastern European risks – click to enlarge.

 

In light of these developments, holding a Swiss or German government bond with a negative yield to maturity is not only an interesting way of losing money the guaranteed way. Rather, it is a very good way of avoiding exposure to the banking system – as are of course gold and cash. The fact that gold has been very strong in euro terms lately should therefore not be surprising and probably constitutes a warning signal.

This brings us to another, related point: someone must always hold the deposit money extant in the system, and euro area money supply growth has accelerated rather noticeably (+11.8% y/y at last count – before the ECB’s QE program has even started). As soon as someone gets rid of deposit balances by buying bonds, gold or stocks, someone else, namely the seller, is faced with the same dilemma. The only exception to this is the withdrawal of cash currency, which removes deposit money from the system. As we have previously argued, securities prices are where the inflationary policies of central banks find expression at present – to say that there “is no price inflation” is inaccurate, as this is only true with respect to consumer goods. In the eyes of the richer strata of the population, cash has become a “hot potato” already, which they are trying to get rid of by buying securities. So we not only see the effects of risk avoidance, but also the price distortion effects of monetary inflation at work.

 

4-Gold in euro termsGold has been very strong in euro terms. Since bottoming in late 2014 at €850/oz., it has rallied to €1,134. This constitutes a warning sign with respect to systemic stability in Europe – click to enlarge.

 

In light of all this, there is still a wide range of possible outcomes. For instance, the holders of cash may become increasingly concerned about the risks of holding deposits with banks, especially if more Cyprus-type financial accidents should occur. This could lead to a run on banks, which would be inherently deflationary if it ends up transforming large amounts of deposit money into cash currency (as a “reverse multiplier” effect would set in). Under the assumption that the European banking system is far weaker than the ECB’s “stress test” results are suggesting, such a run on banks could obviously have grave ramifications.

Another possibility is always that the notion that “cash is a hot potato” eventually begins to spill over from financial markets into product markets. In that case, we could be faced with a sudden change in “inflation expectations”, with more and more money being exchanged for anything that is not money. This could set off a self-reinforcing spiral. At the moment this still seems quite a remote threat, but it shouldn’t be dismissed out of hand, especially as the inter-temporal distortion of the economy’s production structure has kept worsening in recent years.

This means essentially that the amount of consumer goods production has become dangerously low relative to the amount of capital goods production (we will discuss this particular topic in more detail soon). Thus the foundations for a reversal of the current price distortions have been laid. In case of such a reversal, bond holders would likely face large losses, which in turn would tend to accelerate the process.

 

Conclusion

Confidence in the system likely hangs by a much thinner thread than is currently widely perceived. Since “risk asset” prices are soaring in much of Europe, the underlying currents of suspicion are well masked, but that certainly doesn’t mean they don’t exist. While we believe that central bank and regulatory interventions in the market are a major reason why so many bond yields have dropped into negative territory, the role played by distrust in the banking system is probably quite large as well – a suspicion that seems to be confirmed by the strength of the euro-denominated gold price.

Investors are no doubt well aware of the risks still posed by Greece, as well as the risks bank creditors are going to be exposed to with the adoption of the new EU bank resolution directive. Demand deposit holders are legally considered creditors to banks- Although this constitutes a legal perversion of the warehousing function banks originally had with respect to demand deposits, it is a fact we have to live with. Lastly, the recent decision by Austria’s government to discontinue deposit insurance even for small deposits is firstly a harbinger of similar moves being enacted elsewhere in Europe, and secondly raises the suspicion that more financial accidents may already be on the way.

One can always hope fort the best, but at this juncture it would probably be wise to prepare for the worst.

 

Charts by: BigCharts, Vienna Stock Exchange, StockCharts, WSJ

 

 

 

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