To the Point, No.7 - July 31, 2012:Disaster economics brings appetite for safe assets

1. To the Point
Discussion on the economy, by the Chief Economist July 31, 2012
Disaster economics brings appetite for safe assets
 Low policy interest rates and the high risk of recession and deflation are holding
down bond yields, but the disaster risk influencing investors to choose the return
of capital rather than the return on capital may also be important.
 Disaster economics has consequences for economic, and not least monetary
policy. Thus, policy makers must work harder to build confidence and to reduce
fear.
The different reasons for why some bond rates are so low
Cecilia Hermansson
Group Chief Economist Not even the Great Depression pushed bond yields down this far. The US can now
Economic Research Department borrow from the bond markets at a cheaper rate than at any time in the history of the
+46-8-5859 7720 republic, i.e., around 1.5%. Also the German and UK governments can finance their
cecilia.hermansson@swedbank.se debt at a very low cost. Short to medium-term bonds are paying negative real returns.
Still, credit risk, according to the credit default swap (CDS) market, is increasing.
What is going on? Why is the bond market behaving this way?
First, central banks are trying to stimulate the economy by holding policy rates close
to zero and are communicating that future short rates will stay low; and since long-
term bond rates reflect expectations of future short-term rates, they are lowered as
well.
Second, with quantitative easing (QE) where central banks buy government bonds on
the market – or with other measures, like the Federal Reserves’ Operation Twist
where short term-debt is exchanged for long-term debt to lower the longer rates
further – the long-term rates stay low. However, it is likely that the impact on long-
term bonds of the first round of QE was greater than the second’s, and presumably
would be greater than a possible third round’s.
Third, in line with central bank measures, there are expectations of low inflation in
the years to come, as the recovery is slow and disinflation is continuing – this is even
increasing the fear of deflation, at least in Europe and as always in Japan. In
combination with the increased risk of deflation, advanced economies could very well
be in a liquidity trap. In these circumstances, injections of cash by the central banks
fail to lower interest rates further and people hoard cash since they expect deflation
and/or recession.
Fourth, at present investors are prepared to lose money in real terms as bond yields
are lower than the inflation targets of central banks. Thus, private investors, pension
funds, and central banks, among others, are holding US, German or UK bonds,
worrying less about the yields and focussing more on safety. The question, however,
is if investors are underestimating the credit risk. In the US there is a fiscal cliff to
watch out for; in the UK, the outlook for government debt is still very negative; and
in Germany, the bill for the euro area bail-out has most likely not fully been taken
into account. Besides, bank regulations require more holding of sovereign bonds.
When panic is spreading throughout Europe as the risk of southern European
countries defaulting on their debt remains high, and there is a discussion on Greece
and other crisis-struck countries having to leave the euro area, the flight to safety
becomes understandable. Money is leaving southern Europe for northern Europe.
Everything is relative; even if challenges are building up in Germany, the situation is
acutely difficult in Spain, so investors may easily be complacent about Germany.
Gillian Tett, the US managing director at the Financial Times (FT), commented on
July 24th in the FT: “We have entered the world of disaster economics”. She referred
to economists at Fulcrum Asset Management, who blamed a psychological-cum-
generational shift amongst investors on the concept of “disaster”, advanced notably
No. 7 by the economist Robert Barro. The disaster risk has mainly been absent in recent
2012 07 31 decades, but is now coming back, changing the behaviour of investors, so that bond
investments will offer protection rather than produce returns. This would explain why
even negative returns are preferred now.

2. To the Point (continued)
July 31, 2012
And what about the consequences?
Chart 1: The 10 year nominal government
bond yields in the US, UK, Germany and The reasons for low bond yields are most likely combinations of the factors
Japan 1979-2012 discussed above. If the disaster risk has increased, and fear has become the driving
force to invest in US and German sovereign bonds, there are consequences for
17,5 economic policy.
15,0 It is likely that the fear factor will remain for some time since the euro area crisis
will take a long time to solve, the US fiscal challenge is longer term by its nature
12,5
and the Japanese experiences also points to a long adjustment after a financial and
10,0
property crisis. If investors in the US and Europe now prefer protection, instead of
Percent
UK maximising returns, this is line with Japan’s situation where Japanese companies
7,5 minimised debt rather than maximised profits (see Richard Koo). Japan has been
saved from lack-of-confidence runs from abroad since debt is owed mostly to its
5,0
own citizens. Also, since deflation has been common, real bond rates have not been
Germany
2,5 US negative, as could be the case in Europe and the US. So there are differences, but,
Japan
at the same time, also many similarities. In Japan, QE has not been effective. One
0,0
80 83 86 89 92 95 98 01 04 07 10
reason could have been the liquidity trap, but fear could also have played a role. If
Source: Reuters EcoWin this is so, fear may have reduced bond yields in the US and Europe more than the
Source: Ecowin central banks’ QE measures or liquidity injections.
Another matter is the risk of misallocation of capital. During a period of crisis
management, central banks may need to support household consumption, business
investments and even governments, to avoid a deeper recession. But if negative
Chart 2: US nominal and real 10 year real interest rates were to remain for a longer period, saving would be discouraged;
government bond yields (r.h.s) and in addition, investors might prefer speculation in property or financial investments
total capital market debt in relation to to real business investments. Then the factors that created this financial and
GDP (l.h.s) property crisis would be in place to create a new and perhaps even bigger one.
4,0 17,5
<--- Total capital market
debt/GDP
Problems with the incentives for saving are already visible in the linkage of
15,0
3,5 10-year government pension liabilities to bond yields. As yields fall, the present value of future
bond --->
12,5 liabilities rises. Companies must then set aside more funds for pension schemes,
3,0
10-year government
10,0
instead of investing in their businesses. David Kotok, of Cumberland Advisors,
bond (real) --->
wrote recently:
7,5
Percent
2,5
5,0
“What we do know is that worldwide experiences with the zero bound in
interest rates are not universally positive. In fact, we can argue that they are
2,0 2,5 decisively negative. For example, Japan has acquired massive sovereign debt
0,0 and maintained near-zero interest rates for two decades. Have we seen any
1,5 results in economic growth? The answer is no. In the US, low interest rates are
-2,5
resulting in “financial repression.” While this has reduced borrowing costs for
1,0 -5,0 wannabe borrowers, it has also reduced interest earnings for savers. In our
55 60 65 70 75 80 85 90 95 00 05 10
Source: Reuters EcoWin
population, a very large cohort has now experienced a reduction in income due
Source: Ecowin to the low interest rates obtainable on their savings. Is this a wise strategy?
Only time will tell. Unintended consequences always reveal themselves on
their own timetable.”
Also, the Bank of International Settlements (BIS) is concerned with central banks
forcing nominal interest rates to their lowest level in history. Not only can capital
be misallocated, as described above, there could also be spillover effects on
emerging markets and commodity markets. In addition, the BIS sees a risk of
giving too much support to politicians and putting too much faith in monetary
policy to solve all economic problems. To avoid “the disaster risk”, building
confidence is essential. I think central bank policies are needed in the US and
Europe. Policy rates can hardly increase, but QE could play a diminished role
being less effective anyway. However, one has to be vigilant so that Japan’s
mistakes are not repeated – something that might be easier to do than we think.
Cecilia Hermansson
Economic Research Department To the Point is published as a service to our customers. We believe that we have used reliable
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Cecilia Hermansson
+46-8-5859 7720
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