We are not only living in a zero interest rate world but negative rates are becoming increasingly common. In normal times, when investors purchase bonds, they earn interest, also known as yield. In other words, the borrower, usually a government or a corporation pays the investor interest for lending them money. This is similar to the way our home loans and credit cards work â€“ we borrow money from the bank and we pay them interest for the ability to so. But imagine if the bank paid us money to carry a balance on our credit card or to borrow money from them to buy a home â€“ this would never happen right? WRONG.
Over recent months, the tables have turned and what was once unimaginable is now reality. While it is not as extreme as banks paying homeowners to borrow loans, in Europe, some banks are charging savers for parking their money in the bank and in others, investors are paying certain European governments for the right to buy their bonds and lend them money. Take a second to visualize what is happening. Investors in some countries now do better to put their money under their mattresses or in their shoeboxes than to buy government bonds or to put their money in banks.
In mid July, Germany borrowed more than 4 billion euros for 2 years at an average yield of NEGATIVE 0.06%. Yes, investors paid Germany for the right to buy their bonds. Another way to look at it is that Germany is not only able to borrow money from the market but they are earning a small amount of interest on top of it. The same situation also recently occurred in France, Denmark, Belgium and Finland where they were paid to borrow money on a short-term basis. In early June, Denmark cut their official interest rate to -0.2% which means that Danes are paying interest on their certificate of deposits.
Why is this Happening?
This rare but realistic phenomenon is being driven by only one thing – fear. Investors in other parts of Europe are so worried about getting their money back that they are willing to pay a little for the peace of mind of knowing that they will get back their full capital later. Now you may wonder why investors in Europe are willing to pay interest on German or French bonds when they can buy the U.S., U.K. or Australian bonds and still earn some interest and the reason is foreign exchange risk. Investors donâ€™t want to have to worry about changes in the value of the EUR/USD or about the cost of converting their currency back into euros in the future if it means paying a small amount of interest.
Central banks like Denmark on the other hand cut their interest rate to zero because so much money have flowed into their countries and currencies that they have to actively try make their assets unattractive. Fear of being in euros period put significant upside pressure on the Swiss Franc and the Danish Krone. The European Central has already brought their deposit facility rate to zero, which means banks will earn nothing for parking their money overnight safely with the central bank. And at this point, negative deposit rates are no longer unimaginable.
Can This Last?
Of course this trend cannot last because at some point investors will just stop buying bonds and keep their money in cash at banks with zero yield, safe deposit boxes or under their mattresses. The danger of these hyper low yields is inflation, rising yields in countries whose bonds are being avoided and a permanent shift of funds out of high risk nations. The only way to reverse this trend would be growth which is a tall task at or steps by policymakers to reduce the risk of investing in countries outside of Germany, France, Switzerland, Denmark, Finland and Belgium.