Alchemists who profit from negative yield

Posted on September 15, 2016

Pedestrians are reflected in an electronic stock board outside a securities firm in Tokyo, Japan, on Wednesday, Sept. 14, 2016. The Topix index fell for a sixth day at the close of trading in Tokyo as volatility returned to markets ahead of meetings by policy makers in Japan and the U.S. next week amid investor concern central banks around the globe may be reassessing the benefits of existing stimulus measures. Photographer: Tomohiro Ohsumi/Bloomberg©Bloomberg

Why on earth would anyone buy a bond that yields a negative interest rate? That is the $12.6tn question gripping global markets as the pile of negative yielding bonds mounts. If you ask investors, they typically offer two replies: “desperation” (they cannot think of anywhere else to park their funds) or “regulation” (they have to buy bonds to comply with financial supervision rules or investment mandates).

But there is a third explanation: some investors have found ways to make those negative yields pay — and not just through traders “churning” bonds to generate commission.

    The real cause is that government intervention to reinvigorate stagnant economies has left markets so peculiarly distorted that there is potential for canny alchemy — and profits.

    For one example of this, look at dollar-yen cross currency swaps. This rather esoteric corner of finance normally goes unnoticed by the wider world. But right now there are two reasons it merits greater attention.

    First, the Bank of Japan will publish on September 21 a hotly anticipated report about the impact of negative rates. Second, it is evident that recent developments in this swaps market have been bizarre.

    The issue at stake is the spread — in effect, the cost of converting short-term yen contracts into dollars. Three decades ago, this spread was around zero, since demand for dollars and yen was evenly balanced. But when the Japanese financial crisis erupted in 1997-98 the country’s banks grew increasingly stigmatised and the one-year spread widened to minus 35 basis points, meaning in effect that anyone converting yen into dollars paid a penalty.

    After 1999, the spread returned to zero. It has subsequently widened twice at points when financial crises have sparked a global dash into dollars. In 2008 it hit minus 70bp; and in 2011 during the eurozone debt crisis it touched minus 50bp.

    In between, the spread shrank — as you would expect when markets are calm and functioning normally.

    What is peculiar now, however, is that since 2015 that spread has widened and stayed at that level, hitting minus 70bp for one-year swaps. That is in part because Japanese institutions are keen to get hold of dollars, to enable them to buy assets that might produce a return at a time when yen rates are negative.

    Another factor is that the US is reforming its money market rules, which is reducing funding to dollar markets. To make matters worse, emerging market countries want dollars in order to repay loans. The run of persistently wider spreads hurt the profits of Japanese banks and life assurance groups.

    But it also creates a big opportunity for dollar-rich institutions around the world, from Pimco, one of the world’s biggest bond houses, to Chinese sovereign wealth funds.

    So what many of these dollar-rich institutions are doing is cutting deals in this cross-currency swaps market, giving counterparties dollars in exchange for yen — and then using that yen to buy short-term bonds.

    At first glance, it might seem like a bad idea to buy those yen bonds. After all, short-term bonds have negative yields (currently about minus 25bp). But the crucial point is this: the yen loss is more than offset by the dollar gain, meaning that there are profits to be made even by holding negative bonds. So it makes sense that foreigners are piling in.
    Chinese purchases of Japanese bills reached a record cumulative ¥10tn in June, according to Bloomberg
    .

    Now, if you want to be optimistic, you might say that this tale simply shows that central bank actions are working: if Chinese and US investors keep buying short-term yen bonds, that will keep yen rates low.

    This should — in theory — provide stimulus to the wider economy, by encouraging more borrowing. However, if you want to be more cynical about whether negative rates really work (as I am), you could also point out that these market dislocations have become so perverse that they are sapping confidence in a self-defeating way.

    Either way, the question is what — if anything — the BoJ will do next. My own guess is nothing much; these dislocations have become so deeply ingrained in the markets that investors (and policymakers) seem almost inured.

    But if you are ever tempted to wonder about those negative rates, ponder on the alchemy behind this peculiar yen-dollar tale. If nothing else, it should remind us how strange our financial system has become — and the shocks that might occur if, say, yen rates suddenly returned to normal.

    gillian.tett@ft.com

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