In memory of Dr. Andreas Höfert

Why accepting low or negative interest rates?

Interest rates on government bonds are close to zero in many countries. In some European countries, including Switzerland, Germany and France, those interest rates even went into negative territory in July and August. This basically means that investors are giving governments money for free – and in some cases they are even willing to pay the governments for borrowing it. How can we make sense of this situation?

Since interest rates are supposed to reflect inflation, the first thing that comes to mind when seeing zero or negative interest rates is that inflation expectations might be in negative territory. Hence at least real interest rates – interest rates corrected for inflation expectations – would be positive. However, this is far from evident right now. Looking at actual headline inflation rates in August, we find that only one of those European countries has negative inflation: Switzerland. The other rates ranged from 2.1% in Germany and France to 2.6% in Denmark.

In that case, maybe markets expect inflation to go down from its current rate. So let’s look at another number, known as “break-even inflation,” which compares a nominal bond with an inflation-protected-bond to derive the inflation rate at which both will perform equally well. This should correspond to market expectations. Not every country issues such inflation-protected-bonds, but some of them do. According to Bloomberg, on 19 September 2012 we had two- and 10-year break-even inflation rates for the US (1.7% and 2.6%, respectively) and Germany (0.8% and 1.9%, respectively), as well as one- and 10-year break-even inflation rates for France (2.2% and 2.1%, respectively). These positive inflation expectations show that the money investors give to these governments will not only yield close to nothing, it will also lose purchasing power.

Then again, maybe markets just don’t get it. Maybe a Japan-like decade is still ahead of us. Central banks might flood the world with unlimited cheap money, but deflation remains our only fate, as some investors still believe. But if the world really worked like this, if we could take for granted that we wouldn’t face any kind of inflation in the next 10 years, wouldn’t this be the best of all possible worlds for governments? Why would they even bother collecting taxes if they could make unlimited use of the printing press to finance their outlays? In my view, this is the logical flaw in the Japan-like scenario: deflation expectations simply cannot justify zero or negative interest rates.

In the case of Germany, at least, there might be another explanation. Investors are ready to accept negative interest rates because they are speculating on the possibility of a euro break-up – and hence on the possibility of getting paid back in deutschmarks. However, this view is short-sighted.

It is true that the mark would appreciate dramatically against other European currencies after a break-up, and probably against the US dollar, too. But this would have daunting consequences for the entire German economy, not just exporters. Pension funds, banks and insurance companies would have their liabilities in marks but many of their assets in euros, causing tremendous balance sheet problems. If the euro were to break up, the German government, which already carries a heavy debt-to-GDP burden of over 80%, would have to take on even more debt to recapitalize many financial intermediaries.

So by many accounts, government bonds are awfully expensive. Then why buy them? Because as many government-bond bulls would stress, they might get even more expensive in the future, meaning that low interest rates might even get lower – and because there is always a buyer of last resort, the central bank. But put into other words, isn’t this the very definition of an asset bubble?