Deflation and Negative Bond Yields

by George Hatjoullis

At the risk of sounding like a broken record (which of course means I am about to repeat myself and not for the first time) the significance of the odd phenomenon of negative bond yields is not correctly understood. It does not (necessarily) signal recession. It does (necessarily) signal deflation. Recall what a negative bond yield implies. The buyer (lender) is so keen to lend to the borrower (issuer) that the lender will pay the borrower to borrow rather than expect payment to lend. Odd no? So why does such a situation arise?

The keys are default risk and deflation. If the issuer is deemed default free and there is, or expected to be, deflation then it makes sense to buy a risk free bond even at a negative yield. The risk free element means it is as good as cash (at maturity) and in a deflation cash yields a positive real return equal to the rate of deflation. If you hold a pound or dollar or whatever and prices fall by 1% p.a. then your real yield is 1% p.a. This is still a bit odd as you can earn a positive nominal yield by putting your money in an instant access savings account. You can typically get more than 1% nominal which means an even higher real return in a deflation. So why not put your spare cash in the bank?

The simple answer is because over the insured amount (£75k in the UK, €100k in eurozone) the bank deposit is not risk free. It is a liability of the issuing bank. Moreover, ever since 2008, and on the insistence of politicians, journalists and depositors, too big to fail is no longer a feature of banks (see EU Banking Reform, see Cyprus crisis). So if you put over £75k in a separately licensed UK bank you could lose the lot or a significant piece of your deposit. You could try National Savings but this too is limited and not exactly user friendly. Negative yield signals deflation. Does it also signal recession?

There is an assumed one to one correspondence between falling prices and negative economic activity. History does not support this assumption (though I am not going to go into one of those pointless historical comparisons involving constructed data). More important there is no theoretical link. The best way to visualise the problem is to imagine the economy is on a gold standard and supplies of gold are fixed. The price of gold might be steadily rising (in terms of goods and services) so there is deflation. However, economic activity might also be rising (GDP growing) and this could be what is driving the rising price of gold as producers and consumers seek gold to facilitate trade.

Of course deflation and recession can co-exist but then so can recession and inflation. One only has to look at recent economic history. The point of this blog is to remind anyone reading (so I guess not too many) that negative yields do not necessarily imply recession but they do logically imply deflation. I would also argue that negative yields are a direct consequence of the destruction of the (bank created) money supply arising from the move away from a too big to fail view of banks. In the UK the stock of risk free bank money is now capped at the number of separately licensed UK banks times £75k times the number of separate depositors. In effect we just went back on a gold standard and fixed the supply of gold. (I am of course ignoring National Savings which is a bit like a government bond and also the ability to deposit sterling in the branches of EU banks).