Wednesday, 30 May 2012

Interested in negative yields ?

Yields are meant to repay the providers of capital for the risk of tying up their available liquidities into risky projects. The concept is related to the existence of time preference of money: a 1$ today is worth more than a 1$ tomorrow, because lending it entails lost consumption and investment opportunities and because that dollar is subject to inflation. Therefore the only theoretical way in which an interest would be zero, is if the perceived risk of the issuing entity is zero. If this is mesmerizing, than how would one explain the negative nominal yields on Swiss bonds ?

Swiss economic background

Just as banks in Singapore, Luxembourg and the Philippines, Swiss banks have traditionally been known for their secrecy. They do not usually divulge personal and account information about their customers unless there it is specifically requested within a criminal complaint. This made wealthy investors with excess liquidity more and more attracted to park their cash in Swiss bank accounts. Furthermore, Swiss banks are generally perceived as enclaves of conservationism, slow to embrace risky financial innovations. 

Switzerland is a quiet and stable democracy. Its economy is reliant on high technology, knowledge based manufacturing and services, mainly financial services which comprises almost 10% of the national output. The two biggest banks, UBS and Credit Suisse, are global powerhouses. Historically, from 1956 to 2012 the inflation rate averaged 2.7% and its debt to GDP ratio is close to 40%, much lower that the ones of other developed countries. The Swiss enjoy one of the highest GDP per capita and the robust growth in output that recent years brought. 

Low return, inflationary world

Because the perceived threat of sovereign insolvency, devaluation and debt restructuring is so low, the Swiss franc is perceived as a safe heaven currency, one in which investors are more certain than not that they will have back their initial capital. With the global debt crisis, most of the western economies are in a process of deleveraging through currency devaluation and through devaluation, as opposed to the more painful method of deflation and debt restructuring. Because central banks are monetising debts by crowding out the supply  of their sovereign bonds, which paradoxically decreases yields, despite it being an inflationary policy, global returns on traditionally risk-less assets are becoming low enough for them to become risky assets. 

As capital flies from distressed European debt and emerging market debt (probably because the yields they provide are not a sufficient cover for the capital losses that might occur), it finds its way into safe havens. The Swiss franc is one of these currencies. 

SNB and its policy

The currency has been fairly stable against other currencies so far. The Swiss banking sector has seen massive capital inflows which increased the value of a franc relative to other currencies. As a result, exporters find their profits diminished by FX factors and therefore corporate profitability decreases. This is why the Swiss National Bank considers the Swiss franc massively overvalued and pursues policies to devalue it. But it is no match to the QE power of countries with more experience in creating artificial inflation like the United States,the United Kingdom, more recently the ECB and to a lesser extent the Japanese Central Bank. It lost the race to devalue. 

Phillip Hildebrand, at that time the governor of the SNB, in August 2011, upped the ante and announced a peg on the Euro at the 1.20 parity. It kept up until now, although the chances of it to break are high. A great deal of modern currency pegs failed miserably: Klein and Marion (1994,1997) find that for 87 episodes of pegged regimes in Latin America and Caribbean countries in the 1957 - 1990 period, they lasted for an average of 10 months. Perhaps the most spectacular blow-up of a fixed exchange rate was in 1992, when the British Central Bank failed to defend the European Exchange Rate Mechanism, and consequently withdrew the Pound Sterling from the EERM. 

.... that is causing negative nominal yields

Usually sophisticated investors do not keep their available deposits in current accounts. Conversely, the chose to purchase short maturity governmental bonds. Because in current times they are more concerned about getting back their investment, without any hair-cuts, unexpected bouts of inflation, or rapid depreciation of the underlying currency, they have stretched the limits of theoretical finance and accepted negative nominal yields. Make no mistake, the inflation adjusted yields on most governmental bonds are negative so as to ease the repayment burden over time, but we are talking here about nominal yields. Investors in Swiss bonds are accepting to take a guaranteed small loss for the added piece of mind.

So why all the interest in negative yields ? Because they are an abnormality, a freak of financial theory and the best prediction is that they are not going to last long. It would take a good stomach to short long duration bonds (the global economic situation is probably going to get a bit rosier for risky assets in the next 30 years), but the real test is if it is worth shorting 1y to 4y maturities. What do you think ?


  1. If we are to believe there is already at least one, if not more, parallel systems being booted up ready to take over USD reserve currency status then perhaps they are using SWISS to discharge it all back to zero. In theory -/+ = 0. Its all fiat, debt if the debt is totally discharged across the boards, perhaps the SWISS are where its being sucked into its black hole. I can't seem to articulate the feeling/vision I currently have on this, but basically unwind all the +'s into the Swiss, where the BIS sits (outside swiss technically).

    Its all crashing and dont think for a moment, there is NO plan :) Maybe that is easier stated...

    1. You are right, there might be some parallel systems being booted up to take over the USD global reserve currency status, but the Swiss Franc is unlikely to be a major candidate for this role. A tiny percentage of global trade is being done in Swiss Francs, it is not a very noteworthy political powerhouse, nor is its military industrial complex awe inspiring, and it has little to say in the global trade of oil, gas, precious metals and other commodities. The currency reserve status is reserved for the currency of the most powerful and influential state. The issue here is that the balance of power is shifting from the USA and the western world to China and the Eastern world. Thanks for the interesting points your raised!