Why would an investor buy a negative yielding bond?
This headline caught my attention, “Negative interest rates are coming and they are downright terrifying.” The article went on to say that negative rates are counterintuitive, unprecedented, and it’s like a parallel universe.
There is now nearly $17 trillion of negative-yielding bonds across the world. There is a flood of money in the system and nobody wants to take any risk. Federal Reserve Chairman Jerome Powell said it best Friday morning that the U.S. economy is in a “favorable place” but faces “significant risks” at the moment.
I originally thought that overseas investors were buying these bonds because of these significant risks. Why else would a German investor pay -0.60% for owning a 10-year German Bond? Wouldn’t they be better off stuffing the money under the mattress? As I learned more about negative interests, they don’t seem as scary and it’s not a parallel universe.
The reason why an investor would buy a German bond or any bond at a negative rate is that the expectation is that rates will go even more negative. As the yields fall on these bonds, the prices will go up and these investors are actually making money from them. They are losing on the yield and gaining on the principal.
Moreover, they buy these bonds in different currencies and have the potential to make money in exchange rates. If deflation strikes their economy, then it’s a bonus, and they make even more money as money deflates. For instance, if inflation falls 3% in a global recession then they will still make 2.4% everything else equal of a -0.60% yield. The bottom line is that the investors that hold these $17 trillion in bonds expect that they are going to sell them to someone else at a lower rate. And they have been right with this trade so far.
There is a gravitational pull from these overseas bonds that are causing yields to drop in the U.S.. Many investors expect that U.S. rates could eventually turn negative and there is big money to be made if this happens. The Federal Reserve has been too slow to cut U.S. interest rates and it’s causing President Trump twitter tantrums. He is calling Chairman Powell his enemy because other countries are now in quantitative easing and the Fed is way behind the curve. A good argument can be made that the president is right with the case against the Fed. He desperately needs rates lower to weaken the dollar and to fight his trade war.
We would all be much better off without this trade war, but I seem to be in the minority on this one. All the polls show that more Americans approve of this trade war. But I expect that they might change their opinion if their job or investments were suddenly at risk. Most American’s also thought it was a good idea to give mortgages to people who couldn’t afford them. The feeling at that time was everyone should own a home!
The global slowdown is here and the demand for bonds continues to increase. If President Trump gets his wish and the Fed cuts interest rates all the way down to 0%, I believe that his reelection chances go to 0% as well. Americans will not want to pay a bank to hold their money. It’s a dangerous game that he is playing and it’s clear to me that he is losing this trade war. China doesn’t have elections and 2020 is right around the corner. I hope that one of his advisors grabs his phone and tells him that he can’t win this trade battle or at least he should fight it after he is reelected. I expect markets to remain volatile in both directions as this trade war is reaching the boiling point, but it can also end in a single tweet. If the president wants to write a tweet to call a truce, then his advisors can give him his phone back.
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