German negative yields as harbinger of deflation | FT Alphaville

German negative yields as harbinger of deflation

Mohammed El-Erian has penned a few thoughts about Germany’s negative yielding bubill auction and indentifies — quite rightly — that there are major risks associated with this precedent.

Ultimately, as FT Alphaville has also argued, a negative yielding regime of this sort could bring about exactly the sort of voluntary capital destruction conditions that turned the 1930s crisis into a depression.

As El-Erian explains:

Operational stress in Europe’s financial system is also a factor. Due to technical dislocations similar to what America experienced three years ago, some banks are forced to scramble in order to get their hands on high quality collateral, helping to push German yields to artificially low levels. 

The longer these factors persist, the greater the likelihood that other private sector entities will also be pulled in the short-run into buying German securities. Over a longer time horizon, however, negative yields on the bills will reverse course, especially if conditions improve elsewhere in Europe. Yet, even then, there is a risk that a large portion of the new money pouring into German debt could prove more durable given that it is being hardcoded through investor- and depositor-driven changes to investment guidelines and benchmarks.

You can also see it as bad money pushing out the bad a la Gresham’s law. As well as the onset of mega hoarding, which kills the velocity of both money and collateral.

Deposits coming into Germany are being fueled by the sale of other European debt. And since there’s only a limited amount of options for where this can be invested — liquid bunds or bills, or pure deposits (in some cases uninsured) — negative yields are the trade-off for keeping your money in Germany.

You can also view them as the premium that needs to be paid for investing in a state guaranteed security, unlike uninsured deposits.

Furthermore, El-Erian rightly draws parallels with what has been happening in the United States. Similar forces have and are still in play there (though they have, arguably, been better managed by the Fed).

It is these safe-asset seeking, hoarding-related deflationary forces which have come to compromise many central banks’ transmission mechanisms.

It’s also why, as El-Erian indentified here, the Fed’s best policy action at the moment is communication:

“The Fed does not have enough policy instruments to deal with the challenges facing the economy. They’re trying to use communication as an extra tool now. WE have used rates, we have had QE, now you see them using communication, trying to push investors to take on more risk. The problem is two-fold. One is there is disagreement on the FOMC. Secondly, it is not a very effective policy instrument. There are not just limited benefits, but there are also costs and risks. The Fed is in a difficult position. It is trying to be active, but it does not have effective instruments at this stage.”

That’s to say, while the vast majority of the market misunderstands the impact that QE has on collateral markets and the market itself, the threat of QE can serve as a much more useful tool than QE itself. Thus the priority becomes expectation management more than anything else. Making the market think one thing, but do the other. Or as we called it, Jedi Economics. Smoke and mirrors tactics. Derren Brown- style neuro linguistic programming.

Let the market think QE is inflationary. At this stage, that kind of thinking can’t do any harm.

As Ben Bernanke himself wrote in his Great Depression paper “Nonmonetary effects of the financial crisis in the propogation of the Great Depression:

A useful way to think of the 1930-33 debt crisis is as the progressive erosion of borrower’s collateral relative to debt burdens. As the representative borrower became more and more insolvent, banks (and other lenders as well) faced a dilemma. Simple, noncontingent loans faced increasingly higher risks of default: yet a return to the more complex type of contract involved many other costs. Either way, debtor insolvency necessarily raised the CCI.

Which means, from an investors point of view, it all comes down to preferences.

If you are transferring money out of a depreciating asset into a safe asset, of which there are not many, you are prepared to pay over its face value to gain access to the safety it provides.

Either way — until enough safe assets come onto the market — an erosion of capital takes place.

How many ‘safe’ assets there are in the market, meanwhile, is a function of future outlook, growth, innovation and demographics, as well as their impact on living standards.

As the Bank of Japan’s Masaaki Shirakawa noted in this speech, while these deflationary forces are country specific, investors at least have the option of exploiting ongoing demand from overseas for their own benefit to deliver ‘safe returns’.

But as the crisis globalises, these opportunities diminish:

Once interest rates fall to almost zero, however, it becomes difficult to increase the benefit of making investments now. Moreover, when interest rates in other advanced economies are also close to zero as in the current situation, there is limited room left to make use of overseas demand, at least among the advanced economies. In sum, the two channels of monetary policy both become less effective.


In this way, in an increasingly globalizing world, there is a possibility that a central bank will find that unintended effects of its monetary policy eventually come back on itself through their effects on overseas economies and financial markets. In the end central banks should conduct monetary policy based on their assessment of economic and price developments in their respective countries and regions. At the same time, it is also becoming more important than ever to make decisions after considering the complex interdependence of the different parts of the global economy.

In short, we suffer a decline of ‘safe’ assets in the developed world, a situation which calls for united central bank action more than ever.

Related links:

Negative yields at the house of Buba – FT Alphaville
How Germany is paying for the Eurozone crisis anyway – FT Alphaville
The Gross paranormal, a.k.a the time depreciation of money
– FT Alphaville
The decline of “safe” assets
– FT Alphaville