Stiff upper lip as 2 year Gilt goes negative
UK yields go below 0%, but real rate at risk of going higher.
In my “Grab your brolly, Chimney money brings money system to crossroads after 75 years,” I mentioned that the UK bypassing the gilts market and distributing money directly to households might be a warning sign.
A warning in the sense that the UK Treasury might have thought it’s COVID-19 response requirement was going to challenge its ability to honour the IOU implicit in a gilt (bond), and that it was heading for a liquidity trap.
Well, about 3 weeks ago the 2-year gilt (0.5% coupon bond) yielded below zero for the first time in its recorded history.
One year ago, it was yielding 0.69%. last Friday, it was quoted on a negative yield of -0.043%. Today it’s popped up a little to -.012.
The 3, 4, 5 and 6 year versions are also negative, and the 10 year bond is only slightly positive at 0.18%.
Next, inflation in the UK has fallen rapidly from 1.5% as a result of Brexit and COVID-19, to 0.8% last month.
That’s significant, and given it will take some time for things to get back to the UK abnormal, i.e., preparing for a slow reopening and then for the reality of Brexit, it’s possible we haven’t seen the worst of this disinflation.
What this means is that the 2 year real interest rate in the UK is around negative 0.84%, i.e., -0.84%.
In fact, real rates of interest have been plunging in almost all major economies since the GFC.
And, on the expectation that they continue to plummet (and bond prices rise), it’s possible to trade-on those bonds and keep the bond mill turning.
Liquidity trap averted?
It might look that way to risk-on bulls and equities traders, but there is a potential scenario that could turn this on its head.
What if?
Today, I wanted to explore a combination of asset price and consumer price deflation.
In other words, what might happen to real rates and the value of debt (and there’s around $80 trillion more than there was at the time of the GFC) if the trade war, digital disruption of Industry 3.0 sectors, and the COVID-19 response converge into negative growth, lower asset and consumer prices, and then deflation?
Let’s use the UK as an example due to the recent gilt movements, but this applies to all key economies.
We first assume or pretend that the UK is subject to bigger deficits from chimney money handouts, tanking global growth/GDP, and continued opacity around Brexit.
Let’s then pretend that the above scenario worsens, inflation goes negative and households put off purchases on the expectation that goods and services will get even cheaper. Consumer spending and prices retreat, unemployment rises, business and household cash flows drop. Enough investors cash in assets and hoard.
Money supply becomes tighter than a snare drum and its value increases.
And, because flation goes negative, interest rates rise in real terms, i.e., the real interest rate goes higher than the nominal rate after adjusting for deflation. In turn, businesses are less likely to invest and households are even more likely to hoard as money becomes more valuable.
This is good for savers and bad for borrowers because borrowers need to make their existing debt payments with more valuable dollars.
What then happens if there is insufficient cash flow to satisfy those debt obligations which have increased in real terms?
First of all, how did we get here?
In the absence of fiscal measures which directly stimulate investment and wage growth, most governments have left their central banks to indirectly stimulate economies by making borrowing easier and cheaper - QE.
Take the U.S., for example. This is what the Federal Reserve has been doing since November 2008 when Ben Bernanke started QE1.
The reason why QE1 turned into QE Infinity is that direct fiscal policy intervention in the U.S. has been invisible and the Fed has had to carry the entire can.
This has occurred in many other countries for some time now and it feels like politicians have found it too hard to fix the fiscal, so they have left the central banks to do the heavy lifting.
But QE is indirect stimulation by seeking to influence the behaviour of businesses and households (to borrow) in an attempt to boost investment, productivity and consumption.
First it starts with a central bank setting a target rate and engaging in bond buying to achieve the targeted rate at which banks will lend to each other. After adding various costs and margins, banks then lend to businesses and households to stimulate productivity, construction and consumption. Fractional banking and wafer-thin tier 1 equity requirements keep the fractional dollar circulating many times over.
When the economy needs more freight because growth and inflation are still too low, lower interest rates are targeted and more bonds are purchased.
Then a shock occurs, like a trade war and/or COVID-19, and the central bank buys more assets (this time in a pseudo coordinated way with other key centrals following suit) and treasuries guarantee debts and provide chimney money directly to businesses and households.
When it gets worse, treasuries and centrals provide back stops for companies that treasury judges are too big or too important to fail (as per the GFC), and those which cannot repay debt or need to borrow more for liquidity (like today).
Essentially, QE Infinity morphs into Guarantee Infinity, and equities rally as the Fed confirms it is the lender, guarantor and buyer of last resort.
On top of this, and because the USD is the reserve currency, the U.S. Fed extends USD swap lines (which are credit!) to other countries. This allows others to transact and settle contracts and debts in USD – which is by a Yorkshire country mile the most used currency in cross-border transactions and international debt.
At the same time, digital disruption, trade wars, currency wars, Brexit and the economic aftershocks of a pandemic converge.
And, this is how we got here.
Just when the Governor’s advice is to relax and enjoy a restorative cup……
In April, the Governor of the BOE said that the money doled out directly by treasury after increasing its ‘ways and means’ account with the BOE was simply a liquidity measure, and that it would be repaid.
Nothing to see here, he said.
However, a week or so ago the 2-year gilt (bond) yielded below zero for the first time ever.
And in my book, that’s certainly something to see, and requires more than a cup of tea to mull over.
And, the rest of the world is not so different. Japan has negative rates. Switzerland, Germany and France have negative rates and bonds are underwater. The U.S. real rate is already negative. China will not be immune because it’s currency is a managed float and largely pegged to the USD, and if it wants its exports to remain competitive in currency terms it will need to follow suit.
China recently announced a c.US$630 billion stimulus last week, and for the first time it will not publish any GDP growth figures. Instead, it has reported a large contraction last quarter and admitted uncertainty over the future horizon due to ongoing implications from COVID-19. Inflation is currently around 3.3% with interest rates at 3.85%, implying a real rate of 0.55%.
Australia’s inflation popped to 2.2% in April although commentators see this as transitory. A lower rate of 1.9% is expected for this current quarter, year on year. But, with an interest rate of 0.25%, the real rate is somewhere around -2%, so a lot better off (for borrowers) than in many other countries, although savers are moon-walking with deposit rates not covering inflation.
However, for large populations that are at or around the 0% bound, the key risk now is what happens after the COVID-19 support packages run out.
Ongoing liquidity pumped into the system to wallpaper over liquidity issues and to encourage investors to continue to invest/lend, is one thing. That is, lower yields push up bond prices and this keeps QE and the debt mill turning.
However, there could be a point where it won’t really matter how much new money/debt is auctioned off - that’s where there’s insufficient cash flow to support existing debt obligations. And, that’s where we don’t want to end up.
Rising real rates implied if we reach south deflation station.
I’m not predicting anything, I’m just posing a question.
What happens if deflation sets in?
Let’s pretend this happens over time. Let’s assume an interest rate of 0% and negative inflation (deflation) scenarios of -0.5%, -1.5% and -2.5%.
As deflation increases under each scenario, the real rate increases to 0.5%, 1.5% and 2.5%. This is because we adjust for negative inflation and the real value of money increases. This means borrowers are still paying off the same nominal amount of debt, but with dollars that are more valuable in real terms. Debt deflation.
This is further exaggerated under our ‘pretend’ scenario, where there is an increasing level of unemployment and the lack of cash flow to repay debt that’s deflated, i.e., become more expensive.
So, in our example, let’s pretend UK flation reaches -0.8% in light of all of the above.
If UK short term gilt rates are already at 0%, this implies a real interest rate of positive 0.8%.
The point is that despite negative rates looking low nominally, they are a gamble by central bankers that deflation won’t occur at the same time, sending real rates higher and creating crushing debt.
This is not a big gamble when increasing accommodation to look after a short term lack of liquidity, in a non-recessionary environment.
However, after an event like COVID-19 where a meaningful percentage of the global workforce faces sustained business closures/unemployment, and support packages are not enough to boost consumption and prices, it can be a big gamble.
I imagine central bankers won’t want to see real yields rise too high and fast during this current contraction, particularly given they have not been able to drain the great debt lakes, and governments have not been able to fix the fiscal.
On the other hand, the gold standard impeded money printing in the 1930s, so welfare and low interest rates were the only tools. Not so today, but while more printing and debt creation might avoid an inbound train at south deflation station, it does kick a bigger can further down the track.
Sooner or later the presses may need to be re-calibrated from printing money, to printing debt forgiveness slips. Liabilities with no corresponding assets.
Still, if governments cannot fix the growth engine, we can only guess which train track the central banks might select, or be pushed onto.
Mike.
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Image attributions: PBS, AP, BBC, Carnival Films, Masterpiece.