The golden rule used to be: interest rates are positive. Economist Ludwig von Mises based this on the belief that people put a higher value on today’s goods than those in the future. The interest rate is a direct result of the time preference for consumption. John Maynard Keynes explained interest rates in terms of the desirability of money – rates are the reward for sacrificing liquidity. Additionally, there was the argument that negative interest rates would prompt savers to squirrel money away under their mattresses.
Today, the deposit rate is effectively negative in the Eurozone, Switzerland, Sweden and Denmark. Some banks are already charging their customers negative interest rates. Still, cash reserves have not grown exponentially. Undoubtedly there are good reasons for this. Holding your cash at home is a risk. Admittedly, there has been an increase in cash in circulation, but certainly no flight to cash. Even negative-yielding Bunds for maturities up to six years are not under selling pressure.1
With Bunds it may be that investors tend to accept the negative interest rates out of a combination of minimizing risk and the desire to generate profits. Clearly, Bunds are extremely secure. However, it is also possible that bondholders are anticipating a negative inflation rate – deflation – which will compensate for negative interest. Or perhaps investors expect interest rates to fall even further into negative territory which would push bond prices higher. Besides, regulation frequently compels many institutional investors to buy and hold safe-haven bonds.
It is easy to see what is driving negative interest rates. In the past, central banks were able to push short-term interest rates below zero with negative deposit rates but they had limited influence on longer-maturity bonds. However, that changed when the financial crisis hit in 2007. The new unconventional monetary policy includes buying bonds. Since then, central banks have supported pricing by buying sovereign and corporate bonds, thereby depressing yields.
Since March 2015, the ECB has been buying 60 billion euros of bonds every month as part of its QE program. It plans to invest 10 to 20 billion euros in government-agency bonds, collateralized debt obligations and bonds issued by European institutions. Further, the ECB plans to direct the remaining sum of 40 to 50 billion euros into sovereign bonds. Precisely how many sovereign bonds of one country are purchased is decided by the ECB’s capital key – the share of ECB nominal capital held by national central banks (NCBs).
The ECB buys a small proportion of bonds, with the remainder bought by NCBs. To avoid bond-purchase liquidity issues, the ECB has given NCBs the option to choose between sovereign bonds and quasi-government securities. The buyback program is scheduled to run until September 2016. As such, this year the ECB and NCBs are committed to buying sovereign bonds valued at some 450 billion euros. Given that during 2015 Eurozone countries are to issue about 675 billion euros to refinance historical debt and 264 billion euros to finance deficits,2 around one half of these new bonds should be absorbed by the Eurozone’s central-bank sector.
The consequences of this vacuum-cleaner policy are clear: low interest rates. Around 30 % of Eurozone sovereign bonds now carry negative interest rates.3 Price increases for higher-risk securities show that this has led to evasive activities by investors. Corporate bonds, real estate and equities with attractive yields are all popular. The wide-scale fall in yields prompted by QE also has consequences for the real economy. Such a low-interest-rate environment could encourage companies to be more willing to take on debt to invest. This in turn would improve the Eurozone’s growth prospects.
Massive ECB bond-buying program*
The bulk of sovereign bonds with a nominal value of 6.7 trillion euros4 is in fixed ownership in the Eurozone. As such, QE is anything but simple. In 2015, the estimated volume of newly issued Italian sovereign bonds is 264 billion euros compared with anticipated ECB and Banca d‘Italia purchases of around 58 billion euros. In Germany, the ratio of new Bund issues to ECB buying volume as part of the QE program stands at a little over one half this year.
Consequences of QE
Evidence justifying the launch of ECB QE has been increasing since mid-2014. These indications, and not least the start of QE in March 2015, have caused the yield curve to flatten. The expectation of the massive bond-buying program worth 1.14 trillion euros, due to run till at least September 2016, has prompted negative yields on Bunds with a maturity of up to six years.