ECB dragging us deeper into madness
The European Central Bank will doubtless cut its overnight deposit rate even deeper than the current -0.4 per cent at its next meeting in September. That doesn't mean it's the right way to try to breathe life into the euro zone economy. It might just make things worse.
By the time the ECB's governing council gets around to making the cut official, it's highly likely that the benchmark yield on 10-year German bonds will already be deeper in negative territory than the central bank's deposit rate. HSBC analysts reckon 10-year bunds will end 2019 at a mind-boggling -0.8 per cent. You now have to pay to hold any kind of German debt from the shortest maturities right out to three decades.
Given the expectation of the ECB cut, it's no surprise that traders are pricing in more stimulus. But we're entering dangerous territory here, not least because the plunge in yields is also dragging down long and ultra-long maturity bonds. There's something seriously wrong in the euro area when lending money to Austria for 100 years produces an annual return of about 75 basis points.
That longer duration bonds are behaving like this isn't just a concern for yield-starved bond investors, it also represents a potentially critical problem for the real economy. That's because it removes the incentive for the finance industry to take risk: If lending overnight yields only slightly less - or sometimes even more - than lending for longer-term investment, then why bother extending credit?
German debt already yields more for three-month paper than it does three-year bonds, a phenomenon known as an inverted yield curve. Such inversions usually indicate a recession is headed our way, but they can actually cause recessions too if they're prolonged. They create a disincentive to invest if the so-called "time value of money" (the higher cost that debt issuers usually pay for borrowing longer) stays reversed for a protracted period.
The recent plunge in yields in the 10-year to 30-year range is the really scary bit of this phenomenon and is the last domino to fall. The longest maturity debt is falling in yield faster than shorter-dated bonds. The traditional yield curve, where interest rates rise as durations get longer, is imploding...
