Wednesday, September 12, 2012

Life in the negative real yield environment II

I am convinced that negative real yields are a phenomenon which will spread to an increasing number of assets and which will be with us for the rest of this decade. I have suggested earlier on (see "Life in a negative real yield environment" dated August 21) that negative real yields not only provide an easy monetary environment but that they also help to lower debt-GDP ratios over time. Contrary to popular opinion, high inflation rates are not a necessary condition to lower debt-GDP ratios. As long as deflation is averted, ultra-low nominal bond yields provide for the necessary low/negative real yields.
In the Eurozone, the ECB first pushed real yields on Germany Bunds into negative territory via cutting the repo/depo rates to record lows. Thereafter, with the help of the LTROs announced last December, it was successful in driving real yields on the so-called semi-core markets (Netherlands, Finland, France, Austria, Belgium) into negative territory. Finally, with the help of the announced Outright Monetary Transactions it aims to do the same for peripheral bond yields (and I think they will be successful).

Negative real yields have frequently been used in history to lower debt-GDP ratios over a time horizon of about a decade (see "The Liquidation of Government Debt" by Reinhart and Sbrancia, NBER Working Paper 16893, March 2011 - thanks to Peter Schaffrik for directing me to this paper). To quote:
"Throughout history, debt/GDP ratios have been reduced by (i) economic growth; (ii) a substantive fiscal adjustment/austerity plans; (iii) explicit default or restructuring of private and/or public debt; (iv) a sudden surprise burst in inflation; and (v) a steady dosage of financial repression that is accompanied by an equally steady dosage of inflation."
In the current environment, higher growth is difficult to achieve amid the need to bring down budget deficits, the low rate of trend growth in Western countries and increasing headwinds from demographic developments. Austerity programmes work only in the medium-to-longer term and initially kill off growth and hence can even raise indebtedness. Default/restructuring has frequently been used in the case of foreign currency debt (because there was no other option left) which is not the issue in the Eurozone at present. I do not expect a surprise burst in inflation given the ongoing deleveraging (which limits the availability of credit in the broad economy and hence is deflationary) and the high amount of spare capacity/high level of unemployment. I have been of the opinion that we will see a slow reduction in debt-GDP ratios on the back of very low nominal yields, moderate but positive inflation and hence negative real yields. This is exactly the point Reinhart/Sbrancia make as well: "We find that financial repression in combination with inflation played an important role in reducing debts. Inflation need not take market participants entirely by surprise and, in effect, it need not be very high (by historic standards). In effect, financial repression via controlled interest rates, directed credit and persistent, positive inflation rates is still an effective way of reducing domestic government debts in the world’s second largest economy-- China."

The reduction in real yields has been the key factor driving nominal yields lower
 Source: St. Louis Federal Reserve

Reinhart/Sbrancia attribute negative real yields almost exclusively to financial repression on the back of explicit or indirect caps or ceilings on interest rates as well as the creation and maintenance of a captive domestic audience that facilitates directed credit to the government. At present, however, I think we have only a mild form of financial repression at work (short-end yields are set at or close to 0% by central banks), rather I see some additional reasons why longer-term real yields have dropped so sharply since 2009 (see chart): Given that longer-term growth expectations have dropped markedly and demand for capital is weak amid the ongoing deleveraging/low level of investment, the risk-free "neutral" longer-term real yield has come down significantly compared to the time period leading up to the financial crisis. Moreover, central banks have started bond-buying programmes (quantitative easing) to directly lower bond yields and have provided a very high amount of liquidity to the banking sector (which the banks at least partially used to buy sovereign bonds) which also resulted in lower bond yields. The latter is clearly not a traditional "repression" tool which would rather see banks being forced to buy government bonds via changes in regulations rather than incentivise them to enter carry trades at free will via the provision of unlimited quantities of liquidity.
Hence, so far the "repression" element needed to bring real yields into negative territory appears softer than in the past. However, given that ultra-low/negative real yields are needed for a long time (10 years) to bring down debt-GDP ratios significantly, I think that at a later stage (i.e. in 3-5 years), stronger "repression" elements will become a distinct possibility in order to maintain the ultra-low real yield environment.

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