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The Bank of England and Negative Sovereign Yields

August 5, 2016

Enterprise Trust Company

Yesterday, the Bank of England, led by Governor Mark Carney, announced that it would lower its Official Bank Rate to 0.25% from 0.5% and increase its monthly long-term bond purchases from £375 billion to £435 billion. The move was widely expected. Actually it was expected at the bank’s July meeting but at that meeting no change were made. In his post meeting press conference, Governor Carney was quoted saying, “By acting early and comprehensively, the MPC (Monetary Policy Committee) can reduce uncertainty, bolster confidence, blunt the slowdown, and support the necessary adjustments in the UK economy.” Given that the UK had the highest short-term target rate of any developed country in the G8, the questions are: Are UK rates headed for negative territory like so much of the rest of the developed world due to the Brexit and is this a problem?

With regard to the first question, we would say quite possibly. The second question is more important and deserves a bit more discussion. So, what are the problems with negative interest rates?

First, negative interest rates are an obvious problem for investors, insurance companies and, especially banks. In general, the reason that any investor buys sovereign securities is to protect the principal value of their investment and earn a modest yield that will protect the purchasing power of their funds. While purchasing sovereign debt in the current environment may still protect the principal value of an investors assets, forget about maintaining purchasing power. These days investors are paying governments to protect the principal value of their investments. Some might say that in today’s low inflation environment paying for the privilege of principal protection may not be so bad. We would remind investors that they could always use the mattress.

The second problem with negative interest rates stems from the risk associated with rising rates. With little or no coupon to protect against principal losses in a rising rate environment, sovereign debt investors could suffer dramatic losses if interest rates rise precipitously. We would counter this argument with two opinions. Interest rates are not likely to rise precipitously. Additionally, rising rates would likely temporarily hurt an investors portfolio values but reinvestment at higher coupons would offset that loss relatively quickly.

So what is the real problem of negative sovereign yields? The answer lies in the potential distortions that this situation creates in economic decision making by investors. With sovereign yields in negative territory , investors may be tempted to “reach for yield.” This may be accomplished by purchasing high grade corporate or mortgage securities (less of a problem), or by substituting sovereign risk with volatile but high yielding asset classes like dividend paying stocks, real estate or illiquid investments. This change in risk profile can backfire on investors. More problematic than this is the problem that negative sovereign yields create for the banking industry. Deposit gathering banks ordinarily keep a portion of their assets in short duration high grade bonds. With yields on these bonds extremely low or even negative, there is a temptation to reduce bond holdings and increase higher yielding direct lending. This is not necessarily a problem unless the banking sector is reducing its credit guidelines and making riskier loans. In this scenario, the potential for credit losses increases significantly.

Our conclusion is simply this; negative yields are not the end of the world. The important consideration for investors is to not let negative yields distort decision making. The important issue for central bankers is to manage the transition to more normalized rate regimes carefully.

 

Disclosures: This piece discusses general market activity, industry or sector trends, or other broad-based economic, market , or political conditions and should not be construed as research or investment advice. The opinions expressed are those of the author and do not necessarily represent the opinions of Enterprise Bank & Trust. Past performance is no guarantee of future performance. No diversification strategy can guarantee against loss.


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