Negative Bond Yields May Hide Future Currency Appreciation

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Many economists, investors, and financial commentators have been debating how to explain the steadily increasing number of European bonds with negative yields. Why, everyone asks, are people paying money to lend out their money for a set period of time? Why not just put your cash into a bank, a safe deposit box, or your mattress? Several reasons have been advanced as potential explanations, but the most likely is the simplest: the bond buyers actually expect a positive yield thanks to currency appreciation.

Reasons given for the acceptance of ultra-low or negative yields have included liquidity, storage and transaction costs, and convenience. Weirdly enough, in today's world a government bond is more liquid and more convenient than cash in many situations. Nobody wants the hassle or risk of accepting large sums in cash, but sovereign debt from countries regarded as safe is accepted easily as payment for large transactions and also serves as collateral both for loans and for securities margin trading accounts. Also, storage for and transactions with bonds are much simpler and cheaper than storage for and transactions with cash once you start to get into truly large sums of money (hundreds of millions or billions of dollars or euros).

However, none of these explanations can possibly explain the negative yields being seen today. Negative yields can now be found in government bonds from Germany, Finland, Austria, the Netherlands, Switzerland, and Denmark. There are even some negative yields on European blue chip corporate bonds issued by companies such as Royal Dutch Shell, BP, and Novartis. While the above explanations might seem to apply to bonds such as these and explain the negative yield, it cannot because of a simple fact: a better bond exists.

If all these investors were looking for a safe place to park money that was convenient, liquid, and offered low storage and transaction costs, they could achieve all those goals at least as easily with U.S. government and corporate blue chip bonds. Since the U.S. bonds have every feature of the European ones and are paying higher interest rates (by roughly 2 percent), why would an investor purchase a European bond with a negative yield when she could get an American one with all the same features and a higher yield?

The answer has to be that the investor expects the final yield on the European bond to end up as high as if she had bought an American one. Only one thing could create such an expectation: an expected depreciation of the dollar relative to the euro (or Swiss franc or Japanese yen which also have government bonds at much lower rates).

If investors want the advantages others have listed from top rated bonds, they should be choosing the ones with the highest interest rates given equal risk profiles. Since it seems unlikely that American government bonds (or blue chip corporate bonds) are seen as less safe than European ones, investors must perceive a higher expected return to the European bonds. If the euro gains relative to the dollar between now and the bond's maturity, the European bonds could end up returning more to an investor than the American ones will.

Given that the European Central Bank is about to start its own version of quantitative easing and that the dollar has been strengthening against the euro, it might seem counterintuitive for investors to be counting on the euro strengthening versus the dollar. However, apparently the investors are convinced that the Fed will eventually succeed in its quest to create inflation (while also believing that Germany will not allow the ECB to create much inflation in Europe).

The U.S. government has piled up a debt of 18 trillion dollars, more than any of the European countries with negative yields on their government bonds when measured as a percent of GDP. The best way to make this debt affordable, from the government's point of view is inflation which will automatically shrink the debt relative to GDP. Central bankers may try to scare you about deflation (here is why not to fall for that), but the main reason they want inflation is to make debt burdens smaller.

If the dollar drops relative to the euro between now and the maturity of one of these bonds, then somebody can turn dollars into euros now, buy a bond that appears to have a negative yield, wait for a while (either to maturity or until she sells the bond), and then turn their euros back into dollars at a more favorable exchange rate. The gain on the currency transactions must be expected to make up for the loss on the lower interest rate. What these bond yields are telling us is that investors expect the dollar to depreciate by an average of about 2 percent per year over the next decade relative to the euro, Swiss franc, and Japanese yen.

If American and German government bonds are pretty close to exact substitutes on all the features mentioned by others, then why do American bonds have positive yields? The best explanation is expected dollar depreciation. European bonds have negative rates because investors expect to be able to book dollar-denominated gains on those investments thanks to the U.S. government and Federal Reserve destroying the value of the dollar. Or looked at the other way, American bonds have negative expected yields in euros because the expected appreciation of the euro will subtract from the nominal interest rate paid.

While the other explanations offered for negative interest rates may take steps toward explaining the phenomenon, a full explanation of negative bond yields must address why anyone would make such an investment when American bonds with positive yields are freely available and have all the same benefits. The answer that completes the explanation of negative yields is expected changes in the value of different currencies. What looks like negative yields may actually be hiding expected positive returns after accounting for the effect of currency appreciation gains.


Jeffrey Dorfman is a professor of economics at the University of Georgia, and the author of the e-book, Ending the Era of the Free Lunch

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