QE vs Repo 2: Why Negative Rates Are Dangerously Important
If you were offered an investment that promised a rate of return of -0.70% after two years, would you take it?
Most people would say no, yet that’s what German 2 year bonds are trading for in the market (at time of writing).
Let us first consider the “asset management” perspective, which seeks to allocate capital based on rates of return.
Here, negative rates are seen as guaranteed losses on the principal invested, as fixed income investments made by these (large) pools of capital are held long term, if not to maturity.
This is also the perspective through which the financial media, along with most market participants, view negative yields – why would anyone buy a bond that guarantees that they lose money at maturity?
Now let us reframe the question a little.
Instead of asking, “Why would anybody buy bonds that leave them poorer?” Let us instead ask, why would people buy bonds knowing that they would be poorer?
They obviously derive some utility from them, to the extent that they are willing to pay to lend governments cash.
That utility is liquidity from the debts’ use as collateral.
Negative yields do not matter because all these people want is collateral and liquidity buffers that allow them to quickly access dollars in times of financial stress. From this standpoint, negative yields aren’t seen as a liability, just as a cost of liquidity.
Also, because these investors/traders aren’t looking to earn a return from these negative yielding fixed income instruments, they don’t tend to hold them to maturity.
Given the strong trend towards ever lower rates (and thus higher prices) over the past decade or so, this has been a very lucrative trade for them.
This new perspective allows us to see low yields in a more nuanced way.
On top of representing a rate of return (or lack thereof), low yields are also indicative of liquidity scarcity, and thus stress in the broader financial system.
Which brings us back to the global shortage of collateral caused by QE.
For some reason, the Fed and its counterparts decided to purchase assets that the financial system was already purchasing en masse, resulting in a system that is more sensitive to changes in market risk.
What happens when liquidity is scarce and market participants jittery with their collateral and risk exposures?
Markets stampede at the slightest provocation, that’s what.
As downside risk increases, or is perceived to increase, people who have extended leverage to others through the repo market issue collateral/margin calls together. This results in mass liquidations from borrowers who now need to meet these collateral/margin calls.
“Small” episodes of this phenomenon can be contained in just a few markets, and the furious selloff in long dated USTs in 1Q2021 is a result of this (inflation worries are bad for bonds).
“Large” episodes span different markets, as investors/traders sell other liquid assets that they own in order to raise the cash needed to meet their margin calls.
These cross market liquidations are very dangerous, as they can spark further margin calls, to the extent where markets all over the globe are involved, as March 2020 and the financial crisis in ’08 so clearly demonstrated.
As such, negative yields on sovereign bonds represent far more than just an asset management conundrum. They are a warning sign that flashes when demand for collateral, and hence systemic risk, in the financial system is high.
Unfortunately, instead of meeting the system’s demand for more sovereign paper for use as collateral, global central banks choose to actively remove them from markets by implementing QE, making the situation even worse!
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