Negative interest rates are a fascinating topic for professional economists as well as the investing public. Using conventional wisdom, one would think that interest rates earned on investments are never less than zero because investors could just stuff their money under their mattresses for free.

Why would anyone want to pay for the privilege of owing a government bond? Generally nominal rates are positive but negative rates come at times of extreme fear, uncertainty and turmoil, with investors fleeing risk assets to perceived safer assets. We saw this in 2008 when Treasury bill auctions tipped into negative yields. The Treasury market saw this again several times in the weak recovery and as recently as September 2014 with T-bills dropping slightly into the red.

European bonds are already negative

European bonds

The “New Normal” for European government debt is negative rates. Finnish, German, Swedish and Austrian bond auctions have seen negative yields ahead of the ECB bond buying program which starts this month. While the US has seen negative yields in very short term paper, the European market is seeing negative rates in their 5-year auctions; and Switzerland has negative yields going out as far as 13 years. This is unprecedented and has to make you scratch your head. So for a 5-year bond (or longer) in these markets, you have to pay the government for the privilege of owning their bonds. Interestingly, this means investors are likely betting on yields falling even further as the ECB steps in with their €60 billion/month buying program. JPMorgan estimated in January, around $3.6 trillion worth of developed market government bonds (or 16% of its Global Bond Index) was at a negative yield. This is a monetary experiment with no roadmap on how to unwind.

Winners and Losers

In the short term, equity markets are the biggest beneficiaries of negative yields. On a relative basis, equities are more attractive and many firms are overweighting equities versus bonds. Year to date, European equities have been huge winners thanks to the ECB's announced bond buying program. Germany is up 16% and France is up 15%. Corporate profits are also beneficiaries of negative yields. Multinational corporations like Berkshire Hathaway and Apple are issuing extremely cheap debt in the Eurozone and then buying back their own stock to increase earnings growth. Don't expect the US bond bull market to end anytime soon either. With negative yields in Europe, US bonds are looking more attractive and should see money flows into the US. Don't expect rising interest rates in the US in the near future.

With negative rates now a reality, the risks are also rising. Retirees and those on fixed incomes are at risk as they search for income in a negative yield environment. They are forced to take on more risk to chase yield. Yields so far below historic norms raise worries about asset bubbles across asset classes. This could threaten financial stability and will likely increase volatility. The next market crash may be larger and faster than we've seen in the past. 

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