The Deflation Anchor

The amount of global bonds with negative yields remains high. This is acting as an anchor for expectations of higher consumer prices.

It’s a straightforward equation. You lend someone money and they pay you back more money — the principal plus some interest the borrower pays for the privilege of being able to do the transaction. However, since 2014, that has changed with an explosion of debt around the world which has negative yield. What this means is that you lend your money to someone and they pay you back less money — the principal minus interest the borrower charges you for the privilege of being able to do the transaction. You pay someone for the privilege of lending them money. Do this over and over again, and it would appear to be the very definition of insanity. Or is it?

What if the prevalence of negative yielding debt around the world is an indication of a deflationary mood? In a free functioning market, negative yielding bonds would not exist unless investors demanded it. If nobody was investing in this debt, the borrowers would have to offer higher interest yields, above zero, in order to finance their needs. Sure, the central banks have been hoovering up government bonds, keeping yields below zero as part of their Quantitative Easing policies. In that sense, there could be an argument that the bond markets have not been entirely “free functioning.” But the fact that the amount of negative yielding debt remains high is an indication that investors (a category which includes central banks) are, in fact, prepared to accept a negative return on their investments. Why would you do this? You are effectively saying, “I am consciously willing to accept a guarantee of less money in the future.” Although some reasons for doing this include thinking that you have no other options to safeguard your money, you have too much money to worry about it, or you are just ignorant, the economic rationale would be that you believe things were going to cost less in the future.

In that sense, negative yielding debt could be an indication of consumer price expectations. The chart below shows the dollar amount of negative yielding debt outstanding in the Bloomberg Barclays Global Aggregate index (the red histogram) as inverted. We can see that, in 2014, it was virtually nothing, but since then has ballooned to currently $9.4 trillion. Also shown is the average 10-year inflation-linked bond break-even rate for G7 countries, which is a measure of the expected annual increase in consumer prices. A relationship appears to exist which backs up this thesis. Since 2014, consumer price expectations have appeared to rise and fall with the amount of negative yielding debt outstanding.

Amount of Negative Yielding

In fact, if this is the case, one could make an argument that central banks have unintentionally contributed to a deflationary mindset by deliberately trying to drive yields into negative territory. It would not be the first time that unintended consequences of official policy have the exact opposite effect of that which is desired.

As long as negative yielding debt outstanding remains high, a deflationary anchor will, perhaps, continue to act as a weight for price expectations.