Money for nothing
I would never lend money for nothing, unless I was at least getting “chicks for free,” as Mark Knopfler sang almost three decades ago.
But that’s exactly what happened at Wednesday’s German treasury auction, when the two-year bond carried a zero coupon for the first time, meaning it will not make regular interest payments. With strong demand, the yield turned out to be just 0.07 percent, and to my knowledge, no one got a Bavarian fräulein.
Wednesday’s auction was no fluke. The U.S. two-year bond is currently at 0.29 percent. While this value is higher than the all-time low of 0.16 percent, recorded in September 2011, it is still rock-bottom, especially compared to the long-term trend. The same goes for German and American 10-year bonds.
It is true that policy rates in advanced countries have been very low for a while. Markets have been flushed with liquidity by both the Fed and the ECB, but there is more to the story than that. For one thing, these bonds enjoy safe haven status, and therefore benefit from risk aversion. The name of Mark Knopfler’s band, Dire Straits, perfectly describes Europe’s current situation, and Wednesday’s pricing reflected worries that Greece might exit the eurozone. In fact, yields on Dutch and Finnish 10-year bonds, which enjoy AAA status, hit all-time lows on Wednesday as well. American Treasuries and German Bunds are especially attractive, as they are very liquid.
Moreover, new financial rules require banks to hold more safe assets. European banks will have higher collateral needs for their over-the-counter (OTC) derivative transactions, which will now be handled by central counterparties (CCPs) as the result of regulatory reform. A recent report by Morgan Stanley and Oliver Wyman predicts that the shift to CCPs, which are usually pickier than banks regarding the quality of the collateral they will accept, could alone generate demand for an additional $500-800 billion of safe assets. Last but not least, central bank purchases of safe haven government bonds have increased substantially.
On the supply side, several AAA countries have been downgraded by rating agencies and ended up losing their safe haven status during the past year. While U.S. treasuries have not been affected by the country’s downgrade, others, like French and Austrian bonds, have not been so lucky. In its latest Global Financial Stability Report, the IMF notes that safe asset supply could decrease by $9 trillion by 2016, equal to about 16 percent of total projected sovereign debt.
Therefore, even if the eurozone’s debt and banking problems are solved, safe haven yields are likely to stay low. This would mean that Turkey and other emerging markets could see huge capital inflows once the global economy recovers, even if central banks start mopping up liquidity as part of their exit measures.
While such a capital surge would make these countries prone to asset bubbles in the long run, it would also make their bond markets extremely attractive. This is a variant of the story Governor Erdem Başçı used to justify the rate cut of last August. He might be right after all. What a pity he didn’t get the timing right.