In: Finance
Explain why several government bond yields (including German, Finish and Swiss) turned negative in January 2015? Discuss the implications to issuers and bondholders.
In the most literal sense, negative interest rates are a simple case of supply and demand. A bond is a kind of tradable loan. Whoever is selling the bond is offering to pay the buyer interest in exchange for his money. If there isn't much demand for buying the bonds, the interest rate has to go up to make customers more willing to buy. If there's a lot of demand, the interest rate will fall. Mathematically speaking, nothing special happens to this process when the interest rate hits zero. If there's still a lot of demand, then the rate just goes negative. Simple.
In this specific case, a few things drove the supply/demand dynamic.
One was that European investors were very pessimistic about the overall economic outlook for the continent. That was making them reluctant to invest in risky, but potentially high-yielding ventures. Things like government debt from really well-run northern European countries or banal global food conglomerates were in high demand.
The other reason was that European governments are very reluctant to increase the supply of debt available. Germany, for example, was running a budget surplus, which made German debt scarce. A lot of people around the world would have been happy if Germany went and gave a bunch of money to Greece and Spain, or announced a massive infrastructure building plan, or sharply reduced sales taxes. And if it did that, it would entail a lot of new debt, which would soak up demand. But northern European countries weren't responding to high demand for their debt with more borrowing. So prices just keep falling.
Implications to issuers and bondholders
It all got started with Denmark. Denmark doesn't use the euro as its currency. But as an official matter of government policy, it pegs the value of its krone to the value of the euro. But while Denmark's economy looks pretty similar to the economies of Eurozone members like Finland, Germany, or the Netherlands, it's much stronger than Greece or Portugal or Slovenia.
Because of that strength, foreign investors have the notion that in the long-term, the value of the krone is likely to go up relative to the value of the euro. If you think of buying Danish bonds as a currency play, then buying them at negative interest rates can make sense.
This was all a little strange, but not all that unexpected. It just turned out that the dynamics around small countries trying to maintain currency parity with much larger neighbors were a little bit weird.
Things changed in January 2015 when the Eurozone's central bank launched a program of quantitative easing — in other words, printing money and using it to buy government bonds.
Three major motivations that market insiders say were in play: