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How negative rates reshaped the fixed-income markets

THE ESSENTIAL

Negative policy rates have become the most fashionable monetary policy tool and this raises many questions: there is definitely a race to go negative between the central banks, very often against a backdrop of currency depreciation. In this text, we shed some light on the impact of the BoJ’s decision in particular, as the JGB market is one of the biggest sovereign bond markets in the world.

While the impact of negative policy rates on the yen is highly uncertain, empirical evidence already shows that BoJ decision suddenly remodeled global bond yield distribution and may lead to a further search for yield. As we are writing, in fact, negative yield affects a considerable 40% of advanced economies’ sovereign debt in the 1-5 year maturities, strongly up from 27% at the end of 2015, while another 10% is very close to zero.

 

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On January 29, the Bank of Japan (BoJ) joined the club of the central banks setting negative policy rates (after the ECB and its Danish, Swiss and Swedish counterparts). The BoJ has motivated its decision by saying that it wanted to prevent the recent volatility on financial and commodity markets from “delaying the improvement in business confidence of Japanese firms and conversion of the deflationary mindset”. On February 11, the Riksbank decided to cut its repo rate from -0.35% to -0.50% to fight “the risk of weakening confidence in the inflation target and of inflation not rising towards the target as expected”. The ECB is also likely to cut its deposit rate further into negative territory on March 10. Negative policy rates have become the most fashionable monetary policy tool and this raises many questions. In this text, we try to tackle some of these questions, by shedding some light on the impact of the BoJ’s decision in particular as the JGB market is one of the biggest sovereign bond markets in the world.

Is there a race to go negative (with currency depreciation in mind)?

As shown in another article in this issue (“Is the ECB running out of leeway? Some thoughts before the March 10 governing council“), the introduction of negative deposit rates by the ECB, coupled with the expanded Asset Purchase Programme (APP), led to significant portfolio bond outflows. Since then, non-eurozone investors have been net sellers of eurozone bonds and eurozone investors have been net buyers (in very large quantities) of foreign bonds. This has allowed the euro to significantly depreciate in effective terms, however, further depreciation would probably require far more negative rates.

In the case of the Riksbank, the introduction of negative rates was clearly for the purposes of fighting the upward pressure on the Swedish krona versus the euro. The Swedish central bank explicitly mentions the fact that “several central banks pursuing more expansionary monetary policy” may make the SEK appreciate and that it had to react to it as SEK strengthening “would make it harder to push up inflation and stabilise it around 2 per cent”. Over the last two years, the EUR/SEK exchange rate has closely tracked the difference between the ECB deposit rate and the Riksbank’s repo rate. There is definitely a race to go negative between the central banks, very often against a backdrop of currency depreciation. However, even some central bankers have doubts over the future of Negative Interest Rate Policy (NIRP). On February 23, Thomas Jordan, the Chairman of the SNB (whose target for the 3-month money market rate is -0.75%), said: “these unconventional measures cannot be deployed endlessly to achieve desirable monetary conditions. Interest rates, for example, cannot continue to be lowered into negative territory without at some point precipitating a flight to cash”.

We will not tackle directly here the economic impact of NIRP but we can at least try to assess its efficiency in terms of currency depreciation. While NIRP seems to have played a significant role for the EUR and also for the SEK over the last two years, the impact that it might have on the yen is unclear. Actually, the “negative rate” decision has been followed by a sharp appreciation of the yen vs. the US dollar. This brings us to reiterate that the main channel through which negative rates might play on foreign exchange markets is portfolio rebalancing. As such, it is worth having a look at portfolio investment data for Japan. Over the last 12 months (FY 2015), Japanese investors significantly increased their purchases of foreign securities to 7.4% of GDP, 42% of which were US Treasuries and 11% of which were US equities. It is difficult to see how residents’ purchases of foreign securities could accelerate further, given the magnitude of current flows. Over the same period, non-residents purchased Japanese securities worth 4.2% of GDP in net terms, almost all of which were debt securities, while Japanese yields were already close to zero (short-end of the curve) or very low (long-end of the curve). All in all, the already very large portfolio outflows might increase now that Japanese yields have turned negative, but it is far from certain that this would be enough to counterbalance the rising current account surplus (3.3% of GDP in 2015), and thus the impact of negative policy rates on the yen is highly uncertain. However, another crucial question is whether Japanese investors will diversify their bond exposure by purchasing more European bonds. This might have a dramatic impact on the fixed-income markets. 

What is the impact of the BoJ's NIRP on yield distribution in the global sovereign bond market? 

The role of JGBs is quite significant in terms of outstanding debt in global fixed income benchmarks. In fact, among major advanced economies, Japanese government bonds account for more than a quarter of overall outstanding sovereign debt and a very similar proportion also in the short to medium curve segment, namely the 1-5 year segment. Numbers show that the JGB market is larger overall than the corresponding eurozone government bond market and in the 1-5 year segment it accounts for around 24% of the almost USD 11 trillion G4 (US, Euro, UK and Japan) sovereign debt market.

The graphs report respectively on the overall sovereign bond market and on the 1-5 year segment only, and show that quite a dramatic shift in yield distribution took place over the last few weeks, since the BoJ surprised markets by “going negative” on rates. Unexpected NIRP led to almost the entire JGB curve suddenly falling into negative territory in just one day, with longer term yields falling further below zero over the following days and weeks. As the proportion of Japanese government debt that has fallen into negative yield territory rose from 22% to 63% in just a few weeks, the global distribution of yield was reshaped as a result. As we are writing, debt offering a yield to maturity below zero has grown to almost 30% of the total G4 sovereign bond market: it was “just” 13% at the start of the year, almost completely thanks to debt issued by core eurozone countries. At the same time, debt yielding more than 1% fell from 50% to just one third. The ECB’s QE and BoJ’s QQE, as we know, are strengthening the gravitational force to which bond yields are subject, mainly in the short to medium curve segment. If we focus on the 1-5 year maturities only, figures are amazing: negative yield now affects a considerable 40% of debt, up sharply from 27% at the start of the year, while another, not insignificant, 10% is very close to zero yield. The change in the overall distribution of yield is even more dramatic here as US and UK debt is also no longer present above the 1.5% ytm level, while at the very beginning of 2016, 15% was still above this threshold.

QQE reinforced by NIRP likely to impact on asset allocation supporting global search for yield

The link between 10-yr JGB YTM and the BoJ’s JGB holdings gained strength with the launch of QQE, as the chart shows: the recent decision to move into NIRP territory broke the previous link to the south and is likely to increase the effectiveness of the purchase programme, both directly and indirectly.

Since QQE was introduced, domestic Japanese banks have reduced their JGB holdings by a significant JPY 66tn, to an outstanding volume of JPY 100tn, as of December 2015. The same trend occurred at other major financial investors in Japan. Although among banks, the reduction in JGB holdings supported an almost correspondent increase in deposits and liquidity, among insurers the search for yield has already led to greater investment weights being account for by foreign assets, primarily bonds, and a longer duration in JGB holdings. On one side, therefore, negative interest rates may weigh more on banks’ attitudes towards reducing JGB holdings but, at the same time, it may curb the other ongoing trend of increasing deposits accumulated in the BoJ’s current accounts. Another point which has to be kept in mind in terms of potential effects is supply-demand balance for JGBs over the next year, considering the major impact of QQE purchases with respect to net issuance. This may lead to additional pressure on yields. On the other side, some major insurers’ representatives have already stated that they plan to increase foreign debt investments to boost returns affected by the introduction of NIRP. At the same time, the BoJ’s NIRP comes at a time when most eurozone core govies’ yields are negative or very close to negative, and peripheral curves remain one of the major yield suppliers left in the above five-year maturity segment, together with the US and UK bond markets. The latter, however, face a different monetary policy outlook with respect to the eurozone, where the ECB is likely to keep rates and yields very low for a prolonged period of time. Therefore, US Treasuries and UK gilts present a “higher duration risk” vs. eurozone government bonds in this respect.

Conclusion

Negative policy rates have become the most fashionable monetary policy tool and this raises many questions: there is definitely a race to go negative among a growing number of central banks, very often against a backdrop of currency depreciation. BoJ decision to enter into NIRP territory follows similar moves by ECB and their Danish, Swiss and Swedish counterparts: contrary for example to the ECB, however, BoJ NIRP comes after years of on-going and full QQE. Accounting also for this difference and taking into account the race already in place, we guess that the major impact is not likely to be on the currency but mainly on bond yields and possible asset re-allocation. As the JGB market is one of the biggest sovereign bond markets in the world, empirical evidence already shows that BoJ decision suddenly remodeled global bond yield distribution and may lead to a further search for yield if current levels of risk aversion abate. As shown by the numbers and graphs reported in the piece, this is occurring mainly in the short to medium term curve segment, but it is increasingly spreading to longer duration bonds at a time when suppliers of positive yield in the Eurozone are fewer and fewer. To some extent, therefore, the ECB and BoJ “tandem” may become even more powerful in producing a gravity force on global bond yields, finally supporting future search for yield in risky assets, too.

Interest rates cannot continue to be lowered into negative territory without at some point precipitating a flight to cash (Thomas Jordan, SNB Chairman, 23 February 2016)

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BERTONCINI Sergio , Credit Strategy
DRUT Bastien , Fixed Income and FX Strategy
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How negative rates reshaped the fixed-income markets
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