On negative nominal 10 year rates

The news yesterday  (or here) that Switzerland had become the first country to sell new issue benchmark 10 year bonds at a negative yield, is just the latest headline in the extraordinary sequence of events that has unfolded over the last half dozen years.  The story isn’t primarily about Switzerland, but about a global collapse in nominal yields.  Even such allegedly robust economies as the United States and New Zealand have very low interest rates, not that much above the lows –  and, as various commentators have highlighted, these aren’t just multi-decade lows, they are multi-century lows.  In European countries for which there is data, during centuries when there was no trend in the price level (and hence presumably no expected inflation), nominal government yields still seem to have averaged around 3-4 per cent.

Market commentators in the FT story I linked to talk a lot about government policies ( as one says “Bond markets are heavily distorted by government policies. They won’t return to normal until central banks start raising interest rates again.”) but the bigger question is not about specific measures that individual governments/central banks are taking, but about why policy rates have needed to be at zero (probably ideally lower) for so long, and what makes a 10 year bond yield near-zero a better prospective bet than the alternatives.  ECB QE probably is lowering yields in many countries, but that QE (for example) is both being done for a reason, and is unlikely to be some quick panacea

Economic outcomes around much of the world have been staggeringly bad.  In the advanced world, taken together,  per capita GDP has shown little or no growth since 2007 (just before the recession began).  Best estimates suggest that a 2014 vs 2007 comparison for advanced countries isn’t that different than a 1936 vs 1929 comparison (although in most cases the Great Depression slumps were deeper and the recoveries stronger).    When I was working for the NZ Treasury in 2010 I wrote a discussion note suggesting that in many respects that world was less well-positioned then that it had been in 1930, but I’m not sure I quite believed it myself, and it is still sobering to realise just how badly things have gone.

Markets don’t expect much policy tightening in the advanced world in the next few years.  The exception is the US, and even there I suspect they and the Fed will once again have to revise down their expectations.

But what if bond yields are foreshadowing more weak growth and a sustained period of deflation?  We know that equilibrium real interest rates can’t go negative (consumption today will always beat consumption tomorrow, and nature continues to produce positive yields –  think untended fruit trees), but the obstacles to negative nominal rates are (a) for short-term assets only, and (b) reflect statutory/regulatory restrictions not fundamental economics.   If the near-zero bound on short-term interest rates were removed, prospects for higher medium-term nominal yields would increase.  But if it can’t be (or policymakers won’t) removed quickly, near-zero long-term bond yields could make a lot of  sense if, say, a decade of -2% annual inflation loomed.

Nothing guarantees such an adverse outcome, and if it happens it will take conventional wisdom very much by surprise (breakevens on long-term inflation-indexed bonds certainly aren’t negative).  But so has a lot else about the last 7-8 years.  Demographics increasingly don’t support investment demand. Advanced country fiscal and monetary space is all but exhausted, and much of the emerging world also appears to have  run the course of their own credit booms.  Most of those countries still have some policy leverage left but the world looks increasingly as though it is one shock from something very nasty.  Perhaps bond markets are telling as something, and implicitly reflect just such a nasty prospect.

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