What’s that old saying about wood and trees?
For most of us, it’s not all that apparent when you’re at a pivotal point in history.
Last week, however, appeared to be one of those moments when everyone was in a flap over the inverted yield curve.
Until last Thursday, it was an obscure term mentioned in hushed tones among economists and bond-market traders.
Then, suddenly, it was splashed across the newspapers and all over the evening news.
Every time since World War II, whenever long-term interest rates dropped below short-term rates, recession was sure to follow.
That’s exactly what happened on Wall Street the previous night when the 10-year US government bond rate went below the two-year rate.
Stockmarkets duly took fright, investors hit the ejector buttons and trillions of dollars globally were expunged from the value of listed companies.
When bond markets flip, big problems follow
History making it may well have been, but for the past year and a half, a far more significant and insidious trend has been slowly eating away at the very heart of finance.
Forget the inverted yield curve, it’s time you got your head around negative-yielding debt.
Alarm bells ringing on debt
For thousands of years, ever since the dawn of civilisation, there has been a golden rule when it comes to lending; the borrower pays back the loan … with interest.
Anyone who didn’t stick to the rules ended up bankrupt or, depending on the lender, hobbling around on crutches, and perhaps even at the bottom of the ocean wearing cement boots.
That’s no longer the case. In this brave new world, you borrow the money and you also earn the interest.
Right now, lenders across the globe are forking out astonishing amounts of money, knowing they will incur a guaranteed loss.
If you think this sounds crazy, you’re right.
And it tells you everything you need to know, or at least be concerned about, when it comes to the health of the global economy.
By late last week, it had grown to $US17 trillion ($25.09 trillion).
These are loans with negative interest rates. Not only do you not have to pay interest, you don’t even need to repay the full amount.
Who would be mad enough to lend like this? Mostly it is the world’s biggest banks. But there are plenty of investors in the game too.
Alarmingly, around one-third of all government-issued bonds now trade with negative interest rates.
Switzerland is king when it comes to negative-yielding bonds. There is so much demand, that every bond, from one year to 50 years out, is in negative territory.
Germany comes a close second, followed by the Netherlands, Denmark, Japan and Austria. Dozens of countries now have bonds on issue where market interest rates are below zero.
A further $US4 trillion worth of corporate bonds – debt issued by companies – now yield less than zero.
It’s even starting to spill into retail loans. Last week, a Danish bank offered home loans with a minus 0.5 per cent interest rate.
How did we get here?
Negative yields weren’t a thing until the global financial crisis.
In fact, up until then, no one really ever believed interest rates could go below zero.
But as the financial system teetered on the brink of collapse and lending dried up, central banks pulled out all the stops.
They cut cash rates to zero to spur investment, but this mostly only affects short-term rates.
So, they then employed what’s known as quantitative easing, a sophisticated form of money printing, designed to drag longer-term rates lower.
It was supposed to be a one-off, a break-glass-in-case-of-emergency measure, but rates went negative again during the European debt crisis, as the graph above shows.
Now, it’s on again as America’s trade wars with China and the world have begun to bite.
Trade is shrinking, economies are slowing, recession fears are on the rise and the only weapon deployed is the rate cut.
Trade slump drags down global growth
Since late last year, it has made no secret that, if required, it too would resort to quantitative easing.
A fortnight ago, our long-term bond yields dipped below 1 per cent on money markets, in what appears to be a steady march towards zero and possibly even lower.
As bizarre as all this seems, investors still flock to government bonds because they’re considered safe.
That’s how they got into negative territory. The more in demand, the higher the price and the less yield the seller has to offer.
Like the sound barrier, once they broke through zero, there was no holding back.
So far this year, more than 30 central banks have cut rates, many of them from already record lows. And the pace is accelerating.
Most are trying to undercut their currencies, to make their economies more competitive in a futile race to the bottom.
What could go wrong?
The financial crisis a decade ago essentially was a debt crisis.
Too much had built up in American real estate, and investors across the globe unwittingly were caught up in it.
The solution was to throw huge amounts of extra debt at the problem and hope it would all go away.
Now, there are debt bubbles everywhere.
In some countries, it is at a government level.
Remember when everyone was freaking about Greece’s debt levels of 140 per cent of GDP?
China puts that to shame with debt around 300 per cent of GDP. But we’re reassured there’s nothing to worry about because the government controls the banks.
In other places, it is at a corporate level.
American companies now are in hock to the tune of $US9.3 trillion ($13.72 trillion), but apparently that’s not a concern so long as earnings keep rising.
In yet other countries, the debt problem is at a household level.
Australian households are indebted to the eyeballs, at around 200 per cent of income. Most of it is attached to mortgages, leaving our banks horribly exposed.
Until now, ultra-low interest rates have pushed asset prices higher.
Property, stocks and bonds have shot into the stratosphere, widening the gap between the rich and not-so-wealthy.
But with growth slowing, corporate earnings under pressure and wages stagnating across the globe, the pressure is building, creating a stampede to sub-zero interest rates.
The problem is, longer-term, negative rates will undermine the banking system.
Unlike the speculators who have piled into bonds to profit from the trend, banks are forced to hold government securities, and while the losses may not send them broke immediately, they will dent profits.
Where all this ends is anyone’s guess, but this is not sustainable.
Everything we ever knew or thought we understood about finance gradually and with little fuss has been turned on its head.
History in the making? Maybe. Uncharted territory? Absolutely.