Thursday, April 09, 2015

Switzerland's 10-year yields drop below zero

We learn from the Wall Street Journal and everyone else that Switzerland has sold $0.4 billion of CHF-denominated 10-year bonds with the yield minus 0.055 percent. It's the first time in the human history when 10-year bonds went negative although Northern European and German (and, update April 14th, Czech) yields of 5-year bonds have already looked below zero.

Also, Mexico sold $1.6 billion worth of EUR-denominated bonds with the yield 4.2% which is sensible – but the shocking part is that it is a 100-year bond, also the first one in the human history. So far, the most futuristic was a 1%-yield Austrian bond maturing in 2062. These unprecedented numbers open a couple of questions.

First, how is it possible that people are willing to buy bonds with negative yields? I would actually like to know who are the buyers. It seems plausible if not likely to me that they're some government-related entities that don't care about the profit at all. I will discuss this issue at the end.

Don't get me wrong. I don't think that the Swiss yields are unacceptably huge and negative. They are virtually indistinguishable from zero. People may suggest that it's better to keep the money beneath the mattress. But it's not quite safe and convenient, especially because you must be careful that the banknotes beneath the mattress remain valid, and so on.

And some people are so wealthy that the banknotes they would have to store would occupy a lot of room and they simply can't afford to buy an additional mattress. ;-) (This is an inverted variation of the joke about the young family that didn't have enough money to buy diapers. So they purchased a villa in Hollywood and cleaned the baby's buttocks against the grass in their garden.) To pay 0.05% per year for removing these logistic problems is totally acceptable. Nevertheless, there is still a problem: even zero seems insanely low.

This is the Swiss GDP per capita. It's a rather nice exponential curve that I chose because we are talking about Switzerland. Every 15-20 years, the figure doubles. Let's assume that the doubling time is 15 years. This corresponds to nearly 5% growth per year. (But some 2% out of it may be eaten by inflation and only 3% is left because I believe that the graph shows the nominal GDP in capita in USD.) To get zero is too little. And there are investments that "almost certainly" return much more than 0% in 10 years. What about stocks?

You're not guaranteed to get anything. But I think that those who lend things for 10 or 100 years don't really need any hard guarantees, anyway. It's a free capital one may play with a little bit. In average over time and markets, a stock returns 10% a year. There are huge fluctuations comparable to 10% as well but at the very long time scales, one expects these wiggles to mostly average out.

I do think that a well-managed stock portfolio will return more than 4% a year in 100 years if dividends are included and recapitalized – and it may be safer than Mexico's long-term liquidity. At the end, I think that even the Mexican 100-year bond above offers too low yields. There is another problem with the 100-year time scale. The buyer will almost certainly not see the repayment of the bond (and we may ask whether the state of Mexico will live that long, too). When he buys the futuristic bond, he's not financially planning his own life.

Or the bond will be sold and bought many times in the next century – just as if it were a banknote. Well, it almost certainly will. But that also means that its price may fluctuate wildly because the fluctuating estimates of the yields between "now and 2115 AD" will hugely influence the price of existing bonds exactly because 2115 is so far and the relevant exponent is therefore so high. Of course that those speculators who buy the 100-year bonds and who are rational believe that the price of their bonds may go up, perhaps hugely, in coming years because the figure for the long-term Mexican interest rate that is now at 4% may keep on decreasing. But no one can be quite sure about these future wiggles. There is a reason to buy, however: the price of these futuristic bonds may only drop by 100% but it may increase by much more than 100% so the average for the coming years may be positive (and perhaps high). Note that \(1.04^100\approx 50\) so if the figure 4% drops to 0% in 3 years, you will produce a 5,000% profit. ;-)

To make the case for stocks even stronger, right now, the European Central Bank is performing its own version of quantitative easing (buying assorted bonds for newly printed euro banknotes). This procedure will almost certainly continue for more than a year and perhaps much longer. Lots of new cash will appear among the people (those who found the artificially increased price of the bonds high enough for them to get rid of them) and they will want to get some investments (other investments than bonds).

Some of those who sold the bonds to ECB in the process of quantitative easing (QE) may start to spend it. But that's probably a small part: Those who had the bonds probably wanted to postpone the consumption from the beginning and their sale of the bond is just a part of their strategy to save more cleverly.

In this environment, I do think that it's almost unavoidable that people will gradually learn that stocks have become a better investment. The cash paid for the bonds in the QE program will be gradually transferred to the stock market, some trillions of euros. Additional trillions will be moving to the stock markets because of a positive feedback, namely speculators who realize the looming stock price increase caused by the previous sentence.

When the economy is going up, stocks go up for a totally understandable reasons – the corporate profits are going up. But when the economy is doing badly, we got used to the omnipresent stimulation by the national banks that pour kilotons of cash into the economies which must be parked somewhere. Stocks are a natural place where to (re)park this cash. So if we include the "new normal" dovish behavior of the national banks among the assumptions, even a stagnating or decreasing economy may be a reason to expect a growing stock market.

As I wrote before, we may see a persistently higher P/E ratio in coming years as the investors learn to use stocks as long-term cash. This may also reduce the (relative) volatility of stock prices.

At the end, I do think that the existence of these very low interest rates depends on some irrationality and this irrationality will inevitably evaporate. An increasing number of investors will realize that the stocks are more profitable – and perhaps even safer – investments than many of these low-interest bonds. At some moment, the bonds' price has to go down and the market yields must go up.

Before that happens, I think that stocks will almost inevitably be better investments than bonds and people are bound to increasingly learn it.

Now, the continued manipulation of the markets by the governments and central banks has succeeded in prolonging the period in which bonds were profitable. People who own a mix of bonds could have gotten 5% in the last year, too. How is it possible if the yields of newly sold bonds have been around 0% for several years? Well, it's because the bonds whose price went up in the last 12 months were already existing bonds maturing in a relatively distant future and their price increase is derived from the lowered expectations of the yields that they will be generated between now and their (future) maturity.

National banks' procedures of pouring ever greater amounts of cash onto the economies is an ever larger manipulation of the markets (at least some quantities describing the markets, perhaps artificial and not too important quantities) away from some natural equilibrium. A problem is that no one can be sure whether the pendulum will ultimately beat this unnatural force and swing back towards the equilibrium. If it does, we will see reasonable 10-year yields of Western nations such as 3% again. But maybe it won't and we won't. Can't there be an alternative, perhaps catastrophic evolution resulting from these ever more insane interventions, one in which any expectation of a business-as-usual long-term equilibrium breaks down?

Well, I think that if this newly printed money get to the real economy – and it is the goal – we will ultimately see inflation again, and perhaps significant inflation, and banks will be forced to cancel this stimulation because everyone will start to be afraid of hyperinflation and carts full of cash that are needed to buy bread (this fear is still a part of the German psyche, and I would say that for a very good reason and not just the 1920s). This is the scenario agreeing with the expectation that the return to some equilibrium and reasonably high and positive interest rates will happen.

Can there be alternatives? In the previous paragraphs, I was assuming that the buyers of the low-yield bonds have a "free will" which is needed to ask the question whether their act is rational. But who is buying the negative-yield bonds, after all?

I tend to think, and correct me if I am wrong, that most of these negative-yield (or otherwise unattractive) bonds are being bought by government institutions or by banks that are legally obliged to do something like that (in order to have the right percentage of "super safe" papers), not by individual and corporate investors who are freely looking for profit. But if that's the case, then the intervention doesn't help to kickstart the real economy at all because governments and central banks are selling these papers to each other and only change their utterly artificial accounting. These transfers between the government-related accounts don't produce any cars or bread or electronic gadgets, only piles of worthless documents.

Profit-seeking investors with the "free will" are probably not buying these negative-yield bonds because they're not so stupid. Am I wrong? Also, it is not possible for them to sell similar bonds. I think that individuals and even companies still pay vastly more than 0% yields for their loans. So there seems to be some "decoupling" between the real economy and the artificially created (by interventions and government manipulations) economy. Only the former really matters. The decoupling may be getting increasingly obvious so that after some time, even the staunchest manipulators, Keynesians, and similar economic crackpots will be forced to understand that manipulations like that can't reliably help any economy as long as by the economy, we mean something correlated with the people's actual well-being.

We're not there yet and we're surrounded by megatons of irrationality of individuals and (especially?) central bankers, government bureaucrats, and politicians. This irrationality is bound to fade away at some point. However, it may last for a longer time than your solvency. Before this irrationality disappears, sensible people should probably better park their long-term savings in stocks.


  1. Lubos, I am almost sure you are capable of recognizing that behind almost all profit seeking human behaviors there no less lurks 'an irrationality' - albeit not one caused by a lack of mathematical ability or a defunct financial calculator. ;-)

  2. Answer is quite simple for Swiss negative yield bonds: they signify that there is a large worry about impending, World-wide economic collapse. Correct or not, worry have reached the level at which some segment of well to do population is willing to "pay" for some sort of safe money harbor against World-wide economic and banking meltdown. Hence Swiss, negative yield pays for their traditional record and trust. Hence 10 years, this worry focuses on the next few years.

  3. How does the "collapse" destroy the mattresses where you can still get zero?

  4. I don't know what to do with such comments, Peter. People have imperfect information and they are not perfectly rational but the greater irrationality you demand and the greater number of people you want to join, the less likely it is for the irrational behavior to take place.

    The "calculation" that if one gets negative yields for a bond, but zero yields under the mattress, the mattress is more profitable, is not something difficult.

    Yes, there can be a rational reason to buy any bad bonds like that. If the interest rates drop further, perhaps to minus 1% in the Swiss case or 3% in the Mexican case, the price of the bonds will go up. But it's clear that after some moments, the holders of the bonds will be producing loss - that covers both the loss from the negative yields; and the profits of the initial investors who made the profit but sold the bonds in time.

    So I am not denying that someone may make profit from these bonds for vague reasons that are partly rational and clever. But the *average* holder of these bonds up to the maturity is still irrational :-) so if the bonds will go up for a while and then down, the irrationality of the later holders is higher than the cleverness of the initial holders.

    I think all this concept of producing bonds whose price will always depend on such speculations about the human stupidity is counterproductive. Economy should be an environment that optimizes the production of breads, cars, software, or services, not a conglomerate of lotteries and scams.

    Extremely long-term bonds should always be viewed as speculative tools.

  5. I have liked Freeman Dyson ever since I read his old autobiography, "Disturbing the Universe". (from a "The Lovesong of J. Alfred Prufrock", a poem by TS Eliot..).

  6. Thanks for this criticism, I completely failed to realize what my sentence actually conveyed. ;-)

  7. I agree with your analysis. I am glad that my impression that you see banks in capitalist world as always rational actors was a misunderstanding.

    Naturally, since I work in financial sector, I'm also glad that 'peons' will continue paying for my salary, even if I do everything in my power to make their investment profitable as much as circumstances would allow.

    Everyone seems to fear and anticipate some black swan event and history teaches us that they indeed do happen, even if in retrospect, it was openly staring at us and irrationality was in plain sight.

  8. Disclosure: I am also slightly diversified with about 10% in precious metals and cryptographic currencies and 20% cash.

  9. As Keynes famously said, we're all dead in the long-run. He never pretended his policy prescriptions were any more than a short-run fix for a particular moment in history characterized by high unemployment combined with downward sticky wages and powerful trade unions. At least this is my careful reading "between the lines" of his General Theory (which was really a special theory, but he was thinking of Einstein).

    Furthermore, Milton Friedman, who said that inflation is "always and everywhere a monetary phenomenon," showed that monetary policies are far more effective for this purpose. It's all about real wages as they relate to the supply and demand for labor. Expanding the money supply, by causing inflation, could bring real wages down, at least until the big unions caught on and and began to demand cost-of-living adjustments.

    As with everything else in economics, it is all about supply and demand. Too bad so many academic economists today find supply and demand so yesterday, so boring: they want something more interesting, more counter-intuitive. The whole field is in a high state of decadence in my opinion.

  10. What's the odds that these bonds will trade at a premium at some future date? Close to zero?

  11. Just as I thought. I contacted Professor Dyson and he responded confirming my suspicions,

    "This story is a flat lie. Nothing like it ever happened. I never asked for an appointment with Einstein, never cancelled any appointment, and never avoided him. Whoever invented the story should be ashamed of himself. Yours, Freeman Dyson."

  12. I'm just off the phone with uncle Freeman and he says he never heard of you or received such inquiry.

  13. Whenever I read:

    "Central banks are buying them as part of quantitative easing. No matter what the profit is, because they don't do it for profit - they do it to inject money into the economy and fight deflation etc."

    I have this knee-jerk association with memes like:

    "The Glorious Leader is watching out for our welfare and security. The Glorious Leader loves us and cares about us".

    Sorry Jaroslav, nothing personal. In fact, I could have written a response similar to yours, but my anarcho-liberal leanings take over, every now and then. Maybe it is this wine that's making me paranoid a bit.

  14. Dear Jaroslave, right concerning (1), I wrote that I believed that most of these bonds are being bought by subjects not seeking profit, like in the QE itself. But then the actual role of these papers in the economy goes away, doesn't it? Do you agree that the situation you have described above is deeply pathological?

    Concerning (2), commercial banks only put this cash to these lousy bonds because there are excessive demands on their investments' being "safe". Otherwise they would buy other things for the cash. And yes, I wrote about (3) as well, but this is a purely speculative purchase where the buyers only think about variations of the value, and not the intrinsic value, and that's always bad for the markets' role as the setter of prices.

    I showed the GDP growth because the total corporate profits obviously follow a similar curve with a similar rate, and stocks are proportional to these profits, so they should follow the same curve.

    Bonds are a *competing investment* for stocks, and because a buyer may choose what to buy, their yields should be similar - minus the amount sacrificed for higher safety. At any rate, I think that your suggestion that the yields should be the *negative* GDP growth rate seems plain wrong to me.

  15. LOL, I don't believe this story of yours about your telephone call but I do agree that L*e Sm*lin should be ashamed of himself, anyway. ;-)

  16. Feel free to email him yourself.

  17. Didn't you say that you *called him* yourself? Why would I e-mail him?


  19. I do not understand the purpose of this comment.

  20. Dear Luboš,

    I don't know the composition of the market for bonds but institutional investors such as insurance companies and pension funds will be among the big players here.

    In short, a large part of the their assets will need to be in bonds to match their liability outgo. This makes financial sense and is also pretty much required by solvency regulations which necessarily take heed of the security backing those bonds. Of course, bonds issued by government—with its unrivalled ability to threaten violence and extort money from whole populations—give the best guarantee and are therefore the least risky. So they'll be in great demand.

    The point is these institutions are a major consideration in all this too.

    But enough of that. Here's a little OT something that you might find interesting if you haven't seen it before — I'll do a toy version to get to the central idea quickly.

    For the sake of argument let's say you are a large insurance company just selling life annuities. You have untold thousands of future stiff punters on the books and have a good grip on their overall mortality so that at any point in time, for your then current portfolio, you can pretty much accurately forecast what your outgo will be in any given future period (say some future year, or month even), on average that is, namely that the 'law of large numbers' is operating so that the inevitable statistical fluctuations in outgo are small in comparison to the level itself.

    Indeed, as this is the toy version, let's also say that your annuity portfolio is so large that you can completely ignore these random fluctuations and that your crystal ball on mortality is bang on. There, that makes life a little easier! :)

    The term structure of interest rates is a nuisance though, so we'll ignore that as well and say there's just one interest rate for all durations, say i per annum or, equivalently, r per annum when expressed 'continuously', i.e. exp(r) = 1+i.

    Let's say you receive proceeds of A(t)δt from your assets (bonds) and you fork out L(t)δt in liability payments (pensions, for example) in the interval t to t+δt. (Oh yeah, let's also ignore profits and expenses, or just subsume them under L(t).)

    To remain solvent, clearly you want S(r) = ∫ [A(t)-L(t)]exp(rt)dt ≥ 0. (S for surplus.)

    But what if the interest rate suddenly changes, say from r to r+δr? Could you become insolvent? Can you do anything about this?

    Well, δS = S(r+δr) - S(r) = δr.∫ t[A(t)-L(t)]exp(rt)dt + ((δr)²/2).∫ t²[A(t)-L(t)]exp(rt)dt + ...

    For δS = 0 you want the first term to equal zero, especially as you won't know the sign of δr. In effect it says you want the average discounted asset and liability terms to be the same.

    If you can manage that, then you'll get a small second-order profit (from the 2nd term) by having the discounted asset proceeds on a wider spread than your liabilities.

    Of course, you all might be wondering right now what this has to do with the price of eggs.

    Good question. I have often wondered the same thing. But I never got any further. :)

  21. Sorry, John, but forcing the banks to buy nonsensically manipulated bonds because they are "safe" and they need to have a large percentage of assets in "safe" forms doesn't make financial sense because the quantification of the "safety" is based on superstitions - very analogous superstitions about the "low risk" that were applied to mortgages 8 years ago.

    If a government or a central bank is manipulating its currency and bonds in similar grand ways, it makes the whole concept of bonds less safe, despite the poor yields.

    It's always wrong when the market is being manipulated in this way, and it's always wrong when banks are told by clueless bureaucrats from above what they should consider to be safe.

    Again, to mention an example, a 100-year bond is *always* super speculative, whoever has issued it, because thinking about societal events 100 years from now is a textbook example of a "speculation".

    Similarly, very low and e.g. negative-yields bonds which get decoupled from any common sense are also unsafe. When central banks and governments are deciding that they may manipulate the interest rates for governments to be negative and so on, they may also decide that there is no reason to repay anything at some point in the future, or just repay 50% of what they issued. It's a slippery slope. There is no truly higher security here relatively e.g. to diversified stock portfolios.

  22. Dear Luboš,

    No need to apologise! Again, I agree with you. I was simply giving the conventional 'wisdom', not fucking endorsing it! FFS screw that! :)

    The whole thing has gone tits up. We're now all in South-Sea Bubble Land, with added tulip mania. It's criminally nuts.

  23. Hello Lubos,

    the logic of QE is that the central bank buys government (and certain kinds of other) bonds in order to drive their price up (by increasing demand), therefore sending the interest rates down, and making them uninteresting as an investment. This necessarily lowers the rates also for everyone else - because they don't need to compete for funds with the government debt that has been just effectively removed from the market. So the answer is that the papers have been removed from the economy, but their role wasn't - they still influence the real economy by not being there :) And the decrease in interest rates is real - companies and individuals can get money cheaper and, for example, it played a role in the recent fracking boom.

    Of course, all this is one giant mess, nobody knows how it will end and it's a means of solving problems by creating other, even bigger ones. But the new problems are not immediate and are even more difficult to understand, so the public doesn't care much.

    I think the problem of excessive demands for safe investment is not relevant here - the QE is the real reason. This is a problem for institutions like pension funds and it played a big role in the mortgage crisis. There are not enough AAA papers, so I invent some fake ones and when it all blows up, I'm long gone...

    Regarding the GDP/stocks issue, there are actually two distinct ways how a stock price of, say, Rolex can go up. The first is that the company sold more of even better watches and made more profit. Real wealth was created. This growth is certainly positively correlated with GDP growth. The second way is purely monetary: the price went up because of inflation, or because lower interest rates made the stock a better investment. This doesn't really have much to do with the company itself - it's just a "rescaling" of the environment. I don't see any obvious and simple relationship with the GDP growth here.

    The Mexican bond - let's say you just bought a 100 year bond with nominal value $100. You bought it for $2, because the interest rate is 4%. Now three years later, the rates are down to 0%. Why do you think it would be rational for anyone to buy the bond from you for $100? Why would I pay $100 in 2018 for a piece of paper that promises nothing else but that the issuer will pay me $100 for it in 2115? There is no way I could possibly make any profit on it. On the other hand, if I keep the $100 in cash, I can wait a few years until the rates are back at 4% and then invest the money for real profit. By buying your bond in 2018, I would inflict an opportunity cost on myself and lose money. And let's assume that nothing crazy and weird will happen - like Fed buying it from me for $110 in 2019 or that I auction it off at Sotheby's in 2100 for $1M as a rare collector's item.

  24. Dear Jaroslave,

    if the government (it's really a government+central bank which is not quite coherent entity, but let's assume that it is one subject) is able to lower its own rate and make the servicing of its debt cheaper, than it is *not* competing with others because others can't do that.

    There is no reason to expect that this procedure will do the same thing to every other entity's debt, and it doesn't.

    One make disfavor government bonds as a form of investment but there are always all the other things that may be bought as investment - real estate, stocks, and so on. If the future price of the bonds you could buy now is reduced, by reducing the yields, the flip side is that the relative future price of stocks and real estate (and other things) goes up, so those who don't want to spend just buy something else.

    The government can't be forcing people to spend by distorting the price of a particular form of investment. The people have bonds - and haven't spent the cash - because they think that they need a reserve. The price distortion will only be a reason for them to save in another form.

    QE creates a lot of chaos but the aggregate affect on the consumption is largely non-existent and this whole game of distortion of the prices is ludicrous.


  25. It's fairly simple. The western economy is going nowhere until there are more customers for its goods and services, who can pay for them with things other than food stamps.

  26. What many are in the dark about is that QE destroyed the markets natural ability to price itself. It also created a risk free attitude on Wall Street and the banks. By bailing out bad behavior more is guaranteed to occur.

  27. Here's why interest rates can NEVER go up. Not only will there be a massive hit on the bond market, the real estate market will also get crushed. As rates rise, the monthly payment increases causing values to fall as it prices out even more potential buyers. If the housing recovery is this anemic with the lowest mortgage rates in history, what would happen if rates went back up to say even 5% on a 30 yr mortgage? Perhaps another 20% lower in asking price will cause even more people to be underwater on the mortgage. Extend and pretend is the only solution, the banks are counting the uncollected interest and principal payment as INCOME. The banks and the Fed are on a circus tight rope and a snap anywhere on the rope brings down all the clowns no matter where they are standing -- except Goldman of course, they will probably have parachutes for when this happens.

  28. Ask and ye shall receive, eh? ;-)

  29. Surely you understand what is certainly lurking about here is the collapsing demand and population. The UN Low model is already too generous, it would seem, as growth has leap-frogged India and China (and most likely any such future growth elsewhere, as per IMF; tech and westernization will alter behavior before any bursts of growth take hold). Does the graph look familiar? Our love extrapolating the log part of graphs (Moore's law, IPCC and their alteration of this interglacial period to resemble log growth currently, population, etc, all currently on their way to rather quick refuatation). The entire global economy was based on (all the "rules" formed) during growth. That is never more to be the case. The writing is on the wall. Acceptance of population collapse is probably more the inherent reason why the Saudis are dumping their oil now, like aging whores, because decreasing demand (sure, coupled with more advances in shale, etc, and the fact that we are really swimming in resources). And why the future bond yields follow as well (and you are right the governments are who are buying these bonds with all of their abilities, otherwise all abstraction of money would collapse). Nothing ever considered, applies to a zero-growth or negative growth economy. The ball has begun its descent after reaching it's peak. The circus is over (it could be argued at which of the past few bubbles this really occurred). It is of more interest to an Ecologist or Archaeologist as to how all of this is happening, than perhaps a slave of mathematics can fathom. Don't you understand the foolishness of promoting continued market investment? Keynes new in the 30's - [It was discussed as for some future time when increasing capital investment would naturally meet diminishing returns for the system as a whole. Continuing increases in investment by the wealthy would then cause over-investment and result in "conditions sufficiently miserable" to bring the net savings rate of the economy to zero.]. Sound familiar? Trillions dumped into the markets with no interest for those grabbing it, only to return billions. The Swiss have "broke the buck" which is the exact same thing that was realized with the major collapse of US bank in the last crisis for they had to come clean with the same situation to their investors. Everything was truly bankrupt then. Now we yawn that governments are now logically following suit? You surely understand most of this. There is no reasoning or technology that will be able to help us through this. The stone seems to have been cast, and it was nothing that anyone envisioned, or perhaps, ironically, it was exactly what we all wanted. A simple behavioral shift.