The Truth About Negative Interest Rates & What To Expect

However, if the nominal yield is a greater loss than the gain on that trade, demand for the negative-yielding bonds will dry up pretty quick because traders won't be able to profit on the day-trade or swing-trade. I suspect that yields just below zero will not have this problem, However, there is an inflection point below that, at which traders will stop trading, somewhere between -0.01% and -100%.  That inflection point is probably much closer to zero than it is to negative 100%.

All of this will have to be relative between where the trader is domiciled vs what he can get in the rest of the world.  A trader in the Eurozone, for example, may be able to get a -1.00% on his German Bund, which makes the treasury look great even if it is also nominally yielding a negative return, so long as that return is closer to zero on the treasury. (At this point I'd like to leave out the exchange rate and relative dollar strength.  That will complicate the matter too much, not allowing us to understand what is happening.)

All of this only works, so long as inflation remains low or we don’t experience stagflation. If inflation runs high, there will be a progressively shrinking desire for negative-yielding bonds, even if the trade profit is greater than the yield loss, because inflation will wipe out the remaining trade profit.  However, even in a deflationary environment, the bond itself loses purchasing power with a negative yield, and so long as the absolute value of deflation is greater than the absolute value of the negative yield, traders will remain interested in the bonds for a longer period as their purchasing power increases with both the trading profit as well as the gain in purchasing power.  That said, no one wants to see their account balance falling even in this possible scenario of negative yields being lower than deflation and purchasing power still increases, so this will not be tolerated very long. And if the deflationary period is transitory as central bankers will desperately try to make possible, then bond traders won’t go for it at all.

While the possibility of negative-yielding bonds combined with deflation exists, it will not last very long if it happens.  The negative yield destroys capital, which is certainly deflationary as well.  As this happens, bond investors will wake up to the problems this causes for the local fiat currency (in our case, USD), and a crisis of confidence in the fiat currency will begin to form, causing investors to sell the fiat currency.

Central bankers of the world will not tolerate this scenario and they'll pump as much cash into circulation as they deem necessary, wiping out any deflationary forces with ten-fold inflationary forces. Regardless of the nominally stated yield on any bond, the real yield in the market will move significantly higher. 

Because the yields will rise, the price of those bonds must commensurately fall, which is also destructive of capital. For a short period it may actually cause a feedback loop of rising real yields and deflation of asset values, but a rise of prices in the market place. And this will be especially true of retail borrowers who will think they’ll be able to acquire capital at a negative yield (mortgages, student loans, and car loans), but in reality they’ll only be offered rates reminiscent of the early 1980’s.

Borrower Supply Of Bonds

All of the above is for the lender’s/investor's demand side of the bond market, their desire to lend cash in the form of bonds.  As for the borrower's supply side, their desire to borrow in the form of bonds:

Bond issuers want to offer to borrow capital at the lowest rate possible because it will have to be reinvested back into their business for the greatest possible return.  This must be true in order to remove the risk, or at least lower the likelihood as much as possible, of default for both the borrower as well as the lender.  No one wants default.  But the borrower also knows that investors won't lend unless appropriately compensated for the risk they are about to take. Therefore, the borrower must offer something reasonable in return for the risk taken.

However, if the nominally stated yield on the bond is too high, borrowers know that anyone willing to lend may become skeptical of the high yield, even after looking at the company’s financial statements. The lenders will ask themselves why the yield is so high, what is the risk buried beneath the surface that is causing this borrower to offer a higher yield?

The higher the nominally stated yield goes, at first the willingness of lenders increases.  But eventually, there is an inflection point at which the lenders second guess the loan and the supply of capital will begin to reduce as the yield goes too high. Borrowers may even misinterpret this as the yield they offer not being high enough, and they may offer an even higher yield to entice lenders.

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Gary Anderson 7 months ago Contributor's comment

Nice take on bonds. Banks don't want nominal negative bonds and neither do individuals.

Mad Genius Economics 6 months ago Author's comment

Thanks for reading and commenting Gary. I appreciate your feedback and contribution to the discussion.

I don't think anyone wants negative yielding bonds because of the guaranteed loss. Imagine if I asked to borrow $10 on condition I have to pay you back $9.75. You might as well just give me the quarter and call it a day without having to risk the other $9.75 not getting paid back.