It crawls! It creeps! It eats you alive!
The Blob (original version) is a classic, if somewhat dated, 1958 science-fiction horror movie about a growing corrosive, alien amoeboid entity that crashes to earth from outer space inside a meteorite. It devours and dissolves people, growing larger and more aggressive each time it does. The trailer has the terrifying line, "It eats you alive!"
The amount of bonds in the world that have a negative yield continues to rise, making a fresh swing high this month, and now sits at a U.S. dollar equivalent of $10.5 trillion. It looks increasingly likely that the 2016 high of $12 trillion will be surpassed. This debt pile consists mainly of sovereign bonds from Japan and European countries. In a sense, the deflation which Japan experienced in the 1990s and noughties, has now spread, like a crawling, creeping, giant deflation Blob, to Europe in the noughties and 2010s. Will America be next to be devoured by the deflation Blob?
At first glance, bonds with negative yields make no sense. Rational economic agents, conventional analysis tells us, would never lend money to someone and pay them for the privilege of doing so. That's just the point, though. The concept of a rational economic agent only exists in an academic ivory tower. In the real world, economic agents are, in groups, irrational. So the fact that people are lending their cash in the full expectation of receiving less back could be an indication of herding behavior. Being happy with their falling stock of money, though, might also be an indication that people expect prices of the stuff they can buy with that money (goods and services) to fall further. In other words, deflationary expectations.
You would think that negative yields in bonds is a situation that cannot last a long time. Conventional analysts might say that central banks will "create" (price) inflation and economies will get back to "normal." Right. So we'll just ignore Japan's experience of chronic low / negative yielding debt and deflation then? The fact is that negative yielding bonds can be sustained because people can still make money out of them.
This is done by what is known as a classic carry trade and it is the way in which the financial system can still grease the wheels of commerce in a negative yielding environment. If a bank can borrow money for a rolling 3-month period at minus 0.5% and lend that money to a manufacturer for a year at minus 0.25%, the business keeps funded and the bank still makes money. The bank gets paid half a percent to borrow the cash but only pays out a quarter percent to lend it.
The crucial point is this. Negative yielding debt need not be a temporary situation. As long as the yield curve is positive, a negative interest rate environment can be sustained. In fact, as the deflation blob grows, it could become normal.