Interest rate effects are getting more perverse

Something quite weird happened in Europe earlier this week that provides another insight into how deeply into uncharted territory financial markets have moved. Two European companies became the first non-financial companies without any form of sovereign backing to issue bonds at negative yields.

A French pharmaceutical company, Sanofi, sold €1 billion ($1.46bn) of three-and-a-half year bonds with yields-to-maturity of minus 0.05 per cent. German consumer goods group Henkel sold €500 million of two-year bonds with the same yields to maturity.

In effect, investors in the bonds are paying the company for the privilege of lending them money. They have committed themselves to losing money, in terms of both income and capital.

Why on earth would anyone do that? The obvious answer is that they have calculated that they will lose less by paying Sanofi and Henkel to safeguard their cash than the available alternatives. For Henkel’s investors, similar maturities of German bunds yield a negative 0.67 per cent, so they are receiving a yield “premium” over the German risk-free rate.

The European Central Bank has, of course, been imposing negative interest rates on the deposits banks hold with it since 2014 in an attempt, thus far with modest at best success, to force the banks to lend more. The ECB’s deposit rate is currently minus 0.4 per cent.

The ECB’s actions have had flow-on effects, as banks in Europe (and Japan) responded by charging their customers for deposits rather than paying interest on them.

There are now an estimated $US13 trillion-plus ($16.9 trillion) of negative-yielding securities in global bond markets, mainly sovereign or sovereign-backed debt issues. About a third of investment-grade bonds within the eurozone are trading at negative yields.

Some of the sovereign issues with negative yields, like Swiss Government bonds, are long-dated — some buyers are committing themselves, in theory at least, to losing money for 10 years if those bonds are held to maturity.

With the ECB — confronted by the relatively shallow European markets for securitised debt — now buying corporate bonds, there is potential for it to push the market into even more negative territory. So it is conceivable that the buyers of the two corporate issues actually think they might be able to make capital profits on their purchases in the secondary market for them.

For the companies, the opportunity to replace positive-yielding debt with negative yielding debt is a “no brainier”.

For the bond investors, the willingness to invest in negative-yielding securities signals an unprecedented level of risk-aversion and a fear that the positively-returning alternatives might cause them to lose much more.

It might also be interpreted as a vote of no confidence in the ability of the European authorities to rekindle growth in the eurozone, despite the deeply unconventional measures the ECB has been pursuing. The steady flattening of global yield curves would suggest they aren’t the only ones pessimistic about the future.

While companies and governments are taking advantage of the historic opportunity to raise money at ultra-low to negative rates, the environment central banks have engineered appears to be only delivering a faint echo of the effects the policies are supposed to produce.

Banks in the eurozone aren’t meaningfully lifting their lending and companies are using the opportunity to pay down debt, or increase their cash balances, rather than going on an investment spree. It isn’t just investors that are cautious about the economic outlook in Europe or Japan.

There are some windfall opportunities from the interest rate settings. Glencore, for instance, whose bonds were trading at levels approaching half their face value earlier this year, has seen them rebound to just under face value and was able to raise €1 billion this week at a remarkably inexpensive (for a still-leverage resource company) 1.95 per cent in an issue that was nearly six times oversubscribed.

While that’s an endorsement of the aggressive debt-reduction program Ivan Glasenberg has been pursuing, it’s also an illustration of the degree of investor desperation for yield.

The central bank rate settings have some obvious unintended consequences, most notably the fact that they are draining the profitability of Europe’s banks and destabilising insurers and pension funds. Unanswerable questions are how long they will remain in place and how they might eventually be unwound without igniting some quite destructive side-effects.

There does appear to be a consensus among central bankers that interest rates globally, or at least in the developed world, are likely to remain historically low for a long time, perhaps permanently.

That’s an argument that revolves around demographics, productivity and technology and a global savings glut and leads to a conclusion that the “new normal” involves lower growth rates and lower interest rates. It is one that preoccupied the bankers at their recent meeting at Jackson Hole in Wyoming.

Even in the US, where growth rates are respectable and pressure is mounting for the Federal Reserve Board to raise short-term rates for the second time since the crisis, there is solid agreement among policymakers that interest rates will remain lower for longer and that central banks will have to look to unconventional policy tools in future to try to generate growth.

That’s the view of even “hawks” like the president of the San Francisco Federal Reserve Bank, John Williams, who advocates a “sooner rather than later” approach to a series of gradual rate rises.

“History teaches us that an economy that runs too hot for too long can generate imbalances, potentially leading to excessive inflation, asset market bubbles and ultimately economic correction and recession. A gradual process of raising rates reduces the risks of such an outcome,” he said.

Neither the eurozone nor Japan has the “problem” of a “too hot” economy, but there’s an interesting question as to whether leaving interest rates too low for too long might also generate imbalances and asset bubbles that ultimately lead to something unpleasant.

That’s not just a question for Europe or Japan, of course, because the post-crisis policies they and the US have pursued have exported the ultra-low-rate environment globally via bond and currency markets. Private companies being able to get investors to pay for the ability to lend them money isn’t the only perverse outcome of those policies.