Friday, January 13, 2012

What zero bound?

German bond yields turn negative, as reported in the Wall Street Journal.
Source: Wall Street Journal

Negative interest rates are a big puzzle. Easy stories miss the point: "flight to quality," "need for collateral," etc. Those stories don't explain why bonds are worth more than money.  There's no more quality or better collateral than cash!

So why would anyone suffer a negative rate on government bonds when they can hold cash instead?

For some of us it might make sense. Cash is clunky, dangerous and expensive to put under a mattress. Many banks now charge for the privilege of depositing. So an individual might prefer a very slightly overpriced government bond to cash.

But a bank has a better option. Why not just hold reserves? Reserves are like cash, and as safe and liquid (more so) than government bonds. I might have guessed that only people were buying these bonds. It seems I'm wrong (unconfirmed rumor) -- banks are buying and holding the bonds.

So why would a bank hold a bond at negative interest rate rather than hold reserves? Sometimes there are arcane technical, accounting or regulatory reasons, but so far nobody I've talked to has identified one here.

The best story I've heard so far, suggested by one of the smart students in my MBA class, is this: It's a bet on Germany leaving the Euro. If Germany leaves the Euro, it is likely to redenominate its bonds and so pay off in new DM. The ECB is likely to leave reserves in Euros. So, if you want an asset that will pay off in new DM after Germany leaves the Euro, German government bonds are a good bet.

That story pierces the zero bound. There really is no limit to how low bond yields can go if you think bonds might be paid off in a better currency than the one you can stuff in your mattress. 

It sounds a little outlandish, and the chances that Germany leaves the Euro in 6 months seems pretty low to me. Still, it's a nice story. Does anyone have a better one? Remember, you can't answer why bonds look so good -- you have to explain why bonds are a better asset than reserves, for a German bank to hold!


  1. Could they have gone "special", with banks using them for their LTROs with the ECB? That way, a bank has a solid asset (a German bill) on its balance sheet and a cash infusion in February from the ECB in case interbank market freeze or bank-runs risk increase. Not sure though, just an unproven theory.

  2. What would happen if a bank would have a lot of periphery debt and the periphery would default? Which bank is then likely to be saved? The bank whose bankruptcy will increase the supply of German bonds on the market or the bank whose bankruptcy will have a negligible impact on said supply?

  3. It's possible that banks can use the bonds as collateral against loans at even greater negative rates. The banks would still technically own the bonds, but their carry on the trade would be positive.

  4. ECB and German regulators say to banks, "you vill buy zeez bonds or we will send in an army of bank inspectors to endlessly harass you." Your mental model is that banks are independent firms trying to maximize profits so buying negative yield bonds over holding cash is stupid. It clearly is. My mental model is that banks are wholly-owned subsidiaries of the political authorities and do what they're told or else.

    Public Choice > Economics once again.

  5. "There's no more quality or better collateral than cash!"

    I suppose you mean reserves and not the penny jar. Can reserves function as collateral? Suppose a bank is questionably solvent. Is a claim on the bank's reserves as easy to enforce as possession of a government bond? Can possibly insolvent bank A use its deposits at bank B as collateral when there is a systemic solvency risk? Now consider that German debt is the only really risk-free euro-denominated asset and that all of the euro-zone financial institutions need collateral to operate in the current fashion. Paying negative interest on German bills for a short time may be the price of staying in business where the alternative is to unwind a big share of that business.

  6. Perhaps it is better to hold onto them at this point due to the negative yield and the tax implications (withholding and interest tax). If the yield is negative, it will be similar to being taxed twice on the same asset.

    Also, Martin may have a point about the periphery countries...

  7. Don't you need to think about this from the perspective of nominal interest rates not being negative. If you inflation adjust holding reserves that pay no yield and compare that to an asset which provides a yield of 2%, but inflation is 3%. Holding the bond loses 1%, but holding reserves losses 3%.

  8. Another possibility is herd behavior. If investors assume a further worsening EU crisis situation it would be rational to be own extremely safe asset. Other instutions might want to buy even more bonds in the close future. This would drive up prices and the current owners may sell with a profit. The problem now only is: What happens when the music stops playing and everyone rushes to the door?

    1. Herd behavior explains anything and nothing. Herd behavior is a description, not an explanation.

      I believe that the 'challenge' was to come up with a reason for a bank as a rational agent to prefer German bonds to cash at negative yields.

  9. It's a trade that clearly is working, the bonds continue to rise in value, so ride the trend....Interest? Who cares about that in the next two months....

  10. Of course, the obvious problem is that inflation is way too low, as is economic growth. In this context, only aggressive, public and sustained QE, and perhaps cutting IOR, is workable.

    Japan has tried low interest rates and mild deflation for 20 years. The result have been an epic failure.

  11. Aside from your student's hypothesis, I think that Joae's suggestion of herd behavior has some merit. Along those lines, their might be some Armageddon planning occurring. In the event of a complete meltdown which leaves the status of even the ECB in doubt, where would you put your money?

  12. Nice article. Keep up the great work!

  13. Several explanations:

    1) as a primary dealer at the auctions you probably get stuck with some inventory even if you don't want it. Sure, you could pull out, but you want to be the primary dealer for those bunds and bobbles

    2) political pressure, sort of related to 1)

    3) for trading in general, reserves are harder to use as collateral than actual securities.

    4) Related to 3), easier to trade 6 month bills than actual euros if you want to take a view on the direction of the euro itself. For margin reasons, etc.

  14. Ben, Japan HAS tried massive QE. They had a zero interest rate policy for most of the lost decade, and their programs of economic stimulus and bank bailouts are probably responsible for the debacle. In fact, the official interest rate in Japan is still at .1% These programs are having the same results now in the US.

  15. But if negative bond yields in Germany are due to investors betting on the end of the euro, this fact does NOTHING to dispel the possibility of a zero lower bound affecting monetary policy of the US, Japan or any other country that is not a member of a currency union.

    It didn't work.

    Try again.

  16. How about the prospect that the future may be dominated by deflation and that bonds provide a level of income that will as a result, have more purchasing power? The world is awash with "stuff" to buy and what is missing is the number of capable hands to buy the stuff. High priced goods only seem to be falling, whether Flat Screen TVs or houses.

    You may flood the banks with tons of capital, but if they cannot find willing/qualified borrowers to lend or desire by potential borrowers to borrow because they already have a "toaster", you can lower the prices until the weakest producers go out of business or until the survivor s can withstand lower margins.

  17. Couldn't it just be that the banks are speculating that german's bonds prices are going to skyrocket in the next months? They want to make a profit in the secondary market.

  18. There are a million possible reasons for things like this. It's easy to imagine some esoteric accounting rule somewhere that makes it totally reasonable to starting buying bonds into the ground.

  19. "But a bank has a better option."

    But only banks can hold reserves. German bonds can be held by anyone. Arbitrage is not available when everybody else thinks the banks are too risky. Hence the liquidity premium on German bonds.


Comments are welcome. Keep it short, polite, and on topic.

Thanks to a few abusers I am now moderating comments. I welcome thoughtful disagreement. I will block comments with insulting or abusive language. I'm also blocking totally inane comments. Try to make some sense. I am much more likely to allow critical comments if you have the honesty and courage to use your real name.