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By: Eric Sprott & David Baker
On July 18th, 2012, the German government sold US$5.13 billion worth of 2-year bonds at an average yield of -0.06%. Please note the negative symbol in front of that yield number. What this means is that the German government was able to borrow money for less than nothing. When those specific bonds expire in two years’ time, the German government will pay back the original $5.13 billion minus 0.06%. Expressed another way, investors knowingly and willingly bid the German government $5.13 billion in exchange for bonds that will pay no interest and are guaranteed to lose them money on expiration.1 Welcome to the new status quo.

Germany is not alone. Over the past six months, the countries of Netherlands, Switzerland and France have also issued short-term government debt at negative yields. The bond market auctions for these select countries have seen overwhelming demand, making NIRP (Negative Interest Rate Policy) the new ZIRP (Zero Interest Rate Policy).

NIRP is different than ZIRP, however. NIRP causes outright financial destruction. Economies can hardly survive extended periods of ZIRP rates, let alone survive a long-term NIRP environment. It just doesn’t work.

 

From Eric Sprott & David Baker- Markets At a Glance Newsletter:

On July 18th, 2012, the German government sold US$5.13 billion worth of 2-year bonds at an average yield of -0.06%. Please note the negative symbol in front of that yield number. What this means is that the German government was able to borrow money for less than nothing. When those specific bonds expire in two years’ time, the German government will pay back the original $5.13 billion minus 0.06%. Expressed another way, investors knowingly and willingly bid the German government $5.13 billion in exchange for bonds that will pay no interest and are guaranteed to lose them money on expiration.1 Welcome to the new status quo.

 

Germany is not alone. Over the past six months, the countries of Netherlands, Switzerland and France have also issued short-term government debt at negative yields. Like Germany, they’ve been able to do this because European bond investors are so shell shocked that they’d rather park money in a bond that’s guaranteed to only lose a miniscule amount rather than risk losing more in a PIIGS bond that actually pays some interest. In addition, many investors view German, French and Dutch bonds to be cheap options on the break-up of the Eurozone. If the EU currency union collapses, euro-denominated bonds issued by those specific countries may be paid back in re-issued deutschmarks, francs or guilders, which will be far more valuable than the euros that were spent to buy the bonds in the first place… or at least that’s the idea. As a result of this thinking, the bond market auctions for these select countries have seen overwhelming demand, making NIRP (Negative Interest Rate Policy) the new ZIRP (Zero Interest Rate Policy).

The NIRP acronym is misleading, however, because unlike ZIRP, NIRP isn’t actually an official “policy” per se, but rather a symptom of a broken financial system increasingly starved for good ‘collateral’. Aside from those speculating on a Eurozone currency collapse, a large portion of the bond investors participating in NIRP bond auctions are the banks. As the euro crisis has dragged on, banks in perceived “strong” countries like Germany and Switzerland have seen record inflows of deposits from banks in peripheral EU countries, like Spain. As most of these “strong country” banks have been hesitant to lend those deposits out (for obvious reasons), they are forced to park them in short-term government bonds. Moreover, new rules imposed by various regulators such as Basel III have forced all banks to hold a larger percentage of their balance sheet in government bonds, regardless of their country of domicile. The result has been a mad dash into the bond auctions of select “safe” countries just as the pool of available AAA-bonds has been drastically reduced. Banks are piling into NIRP bond auctions today because they have nowhere else to go. This is why nobody seems to be alarmed by the recent ubiquity of NIRP bond auctions – they are merely thought to be a short term phenomenon that will pass in time… just like zero-percent interest rates were supposed to be when they were widely introduced four years ago (sigh).

NIRP is different than ZIRP, however. NIRP causes outright financial destruction. Economies can hardly survive extended periods of ZIRP rates, let alone survive a long-term NIRP environment. It just doesn’t work. Institutional investors like pension plans and life insurance companies cannot earn enough “spread” to function properly. And many aren’t allowed to buy different asset classes that might produce a better “spread”, even if they wanted to. They are stuck holding the AAA government debt issuers – positive-yield, or not.

Negative rates also punish the individual investor. Try going online and using one of the banks’ retirement savings simulators and plugging in a negative expected return – you’ll break the program. The same also goes for the investment advisory business. When so-called safe-haven bonds start to consistently produce a negative return, try charging advisory fees to clients while recommending a 50% allocation to negative-yielding government debt. Advisors can try it for a while, but investors won’t put up with it for long.

The recent emergence of NIRP auctions are a signal that the relationship between governments, banks and investors has broken down. While the market still presumes that NIRP is a short-term phenomenon confined primarily to Europe, the dearth of AAA-assets coupled with banks’ captive bond purchasing suggests it may be structurally enforced for a long time to come. There’s even the potential for NIRP to emerge in the US bond market. As Bloomberg reports, the gap between US bank deposits and loans hit a record $1.77 trillion at the end of July 2012, representing an expansion of 15% since May.2 “Banks have already bought $136.4 billion in Treasury and government agency debt this year, more than double the $62.6 billion purchased in all of 2011, pushing their holdings to an all-time high of $1.84 trillion.”3 The current 2-year US Treasury bill is yielding a paltry 0.29%. If something exciting happens in Europe, what’s to stop the bond market’s typical knee-jerk move into US Treasuries from pushing that yield down past zero? Not much. We could be there before the end of the year, especially if the banks continue to gorge on ongoing US Treasury auctions in the meantime.

The question now is how well the financial system can cope in a relentless low-to-no yield environment for bonds. The last four years of low rates have already wreaked much damage to ‘spread’-dependent industries. One need only look at the insurers: In its latest Q2 report, after reporting an 88% drop in Q2 year-over-year earnings, Sun Life Financial stated that if current interest rates persist its profits for the period from 2013 to 2015 could be hurt by up to CAD$500 million.4 Manulife recently reported a Q2 loss of CAD$300 million, which was mainly attributed to a CAD$677 million charge it took to revalue long-term investment assumptions to account for falling bond yields.5

The pension plans are also deteriorating: According to recent reports from BNY Mellon and Mercer, the funded status of US corporate pension plans hit a record low in July 2012. Benefits Canada writes, “The average funded status dropped 2.9 percentage points to 68.7%… while the latest figures from Mercer show that the aggregate deficit in pension plans sponsored by S&P 1500 companies grew US$146 billion during July, to a record high of US$689 billion.”6 That’s a one-month increase of 27%.7 In the pension business, lower yields on long-term AAA bonds results in higher plan liabilities, plain and simple. As Reuters reporter Jim Saft writes, “To give an idea of exactly how powerful the effect of falling rates is on pension liabilities, consider that, according to Mercer, though US shares rose 1.4 percent in July, the 30-55 basis point fall in discount rates drove an increase in liability of between 3 and 11 percent. In a single month.”8

It’s even worse for the public pensions. According to the Washington Post, new pension accounting rules imposed by bond-rating firm Moody’s are expected to “triple the gap between what states and municipalities report they have in their funds and what they have promised to pay out retirees.”9 If implemented, that new public pension gap will balloon to $2.2 trillion. Michael Fletcher from the Washington Post writes, “Among other things, the new accounting rules from Moody’s and the Governmental Accounting Standards Board (GASB) limit the rate of return on future investments that pension funds can assume for accounting purposes. Most government pension funds assume a 7 percent to 8 percent return, which critics say overstates future investment income.”10 With the US 10-year bond now paying less than 2% a year, assuming a 7-8% return isn’t an overstatement, it’s a fantasy. Chart 1 shows how the last four years of low-to-no rates has impacted the average Canadian pension plan. Extend that trend another four years and we might as well redefine the entire purpose of pensions altogether.

CHART 1: THE SOLVENCY POSITION OF DEFINED-BENEFIT PENSION FUNDS IN CANADA IS AT AN ALL-TIME LOW Indexes (December 1998 = 100)
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a. Solvency position is equal to assets divided by liabilities.
Source: Mercer (Canada) Limited. Last observation: May 2012.

Banks are also suffering from NIRP and ZIRP, as evidenced by the performance of Wall Street’s five biggest banks thus far in 2012. Bloomberg writes, “JPMorgan Chase & Co. (JPM), Bank of America Corp., Citigroup Inc., Goldman Sachs Group Inc. and Morgan Stanley had combined first-half revenue of $161 billion, down 4.5 percent from 2011 and the lowest since $135 billion in 2008. The firms blamed the decline on low interest rates and a drop in trading and deal-making.”11 (Emphasis ours.) Banks make money on the spread between the interest they charge on loans and the interest they pay on our deposits (this is called the net-interest margin). Chart 2 shows the impact low rates have had on the net-interest margin for the Big 6 Canadian banks, and how tightly correlated their profits are to bond yields themselves. The average net-interest margin for the Big 6 was 2.55% in fiscal Q2 2012, while the average yield on the Canadian 5-year Treasury bond was 1.54%. According to our calculations, for every 100 basis point decline in the 5-year Treasury yield, the Banks’ net-interest margin will fall roughly 20 basis points. All else equal, a 1% drop in 5-year bond yields will result in a -15.6% impact on the banks’ net income. Like the insurers, the persistence of low bond yields hurts their profit margins… and the more deposits the banks take on, the more they are inadvertently forced to participate in short-term bond auctions – thereby supporting the very market causing the margin compression in the first place. It’s a vicious catch-22.

CHART 2: CANADIAN BANKS’ NET-INTEREST MARGINS TRENDING DOWN Correlation: 87%
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Source: Bloomberg, Big 6 Canadian Banks’ Financial Reports.

From a government perspective – especially governments like Germany who currently issue short-term debt for less than nothing, the current abundance of NIRP and ZIRP bond auctions represent a sweet irony. Here we are, on the interminable verge of collapse in Europe, and at a time when Western governments have never been more indebted, and bond investors are lining up to pay for the pleasure of owning their bond paper! It’s actually quite ridiculous. But no matter how much pain the current low-to-no yield environment causes the rest of the financial industry, governments will not do anything to change their current set-up. No government is incentivized to proactively raise their bond auction yields for the sake of savers, and barring the surprise emergence of major inflation, no central bank would ever raise interest rates and risk curtailing their expensive efforts to foster growth through money-printing. The banks’ continuing need for safe “collateral” means they’ll buy government bonds at virtually any price, leaving the governments with a “captive” buyer for their bonds. It’s almost perfect for the governments… and as it now stands, unless the banking system diversifies into different forms of AAA-collateral (like gold), or until we experience a default or major inflation – both clearly negative events, investors will be forced to survive with a AAA-bond market that pays absolutely nothing, just like Japanese investors have suffered through for the past twenty years.

Under widespread NIRP, pensions, annuities, insurers, banks and ultimately all savers will suffer a slow but steady decline in real wealth over time. Just as ZIRP has stuck around since the early 2000’s, NIRP may be here to stay for many years to come. Looking back at how much widespread damage ZIRP has caused since its introduction back in 2002, it’s hard not to expect that negative interest rates will cause even more harm, and at a faster clip. In our view, NIRP represents the death knell for the financial system as we know it today. There are simply too many working parts of the financial industry that are directly impacted by negative rates, and as long as NIRP persists, they will be helplessly stuck suffering from its ill-effects.

Although it’s been a quiet summer for “hard assets” like gold and silver, this low-to-no rate environment should prove to be beneficial for them over time. The tide is definitely turning in their favour. Various bond commentators have recently come out in support of hard assets, including PIMCO’s Bill Gross, who opined in his August month-end letter that, “Unfair as it may be, an investor should continue to expect an attempted inflationary solution in almost all developed economies over the next few years and even decades.”12 NIRP and ZIRP are critical components of that solution, and are here to stay until something unpredictable disrupts the current relationship between the banks and government bond auctions. In our view, the factors that have led to the emergence of NIRP bond auctions are the same factors that will drive demand for physical gold in the coming months: savers have nowhere to go for a “safe” return. It’s only a matter of time before they realize they’ve overlooked a unique financial asset that would perfectly suit their needs. When they do, we would strongly advise them to take delivery.

a. Solvency position is equal to assets divided by liabilities.
Source: Mercer (Canada) Limited. Last observation: May 2012.

1 Bartha, Emese and Chaturvedi, Neelabh (July 18, 2012) “Negative Yield on German 2-Year Note”. Wall Street Journal. Retrieved on August 8, 2012 from: http://online.wsj.com/article/SB10000872396390444330904577535102520070554.html?mod=googlenews_wsj
2 Eddings, Cordell and Kruger, Daniel (August 20, 2012) “Banks Use $1.77 Trillion to Double Treasury Purchases”. Bloomberg. Retrieved on August 20, 2012 from: http://www.bloomberg.com/news/2012-08-20/banks-use-1-77-trillion-to-double-treasury-purchases.html
3 Ibid.
4 Perkins, Tara (August 8, 2012) “Sun Life hammered by markets, low rates”. The Globe and Mail. Retrieved on August 10, 2012 from: http://www.theglobeandmail.com/globe-investor/sun-life-hammered-by-markets-low-rates/article4470289/
5 Reuters (August 10, 2012) “Manulife takes loss, to revisit profit target”. Reuters. Retrieved on August 12, 2012 from: http://in.reuters.com/article/2012/08/09/manulife-results-idINL2E8J90LV20120809
6 Benefits Canada (August 3, 2012) “U.S. pensions hit all-time funding low”. Benefits Canada. Retrieved August 5, 2012 from: http://www.benefitscanada.com/pensions/other-pensions/u-s-pensions-hit-all-time-funding-low-31130
7 Mercer (August 3, 2012) “US Corporate Pension Plans’ Funding Deficit Reaches All-Time High”. Mercer. Retrieved on August 21, 2012 from: http://www.mercer.com/press-releases/funding-deficit-reaches-all-time-high
8 Saft, Jim (August 14, 2012) “Negative rates and pension pain”. Reuters. Retrieved August 14, 2012 from: http://www.reuters.com/article/2012/08/14/us-column-saft-idUSBRE87D03U20120814
9 Fletcher, Michael (August 16, 2012) “New rules expose bigger funding gaps for public pensions”. The Washington Post. Retrieved on August 16, 2012 from: http://www.washingtonpost.com/business/economy/new-rules-expose-bigger-funding-gaps-for-public-pensions/2012/08/16/c183fe1a-d507-11e1-b2d5-2419d227d8b0_story.html
10 Ibid.
11 Eddings, Cordell and Kruger, Daniel (August 20, 2012) “Banks Use $1.77 Trillion to Double Treasury Purchases”. Bloomberg. Retrieved on August 20, 2012 from: http://www.bloomberg.com/news/2012-08-20/banks-use-1-77-trillion-to-double-treasury-purchases.html
  1. As soon as the government creates a situation where the expropriation of $6 trillion in  IRA and 401K accounts takes place, the funds will be rotated into government bonds.  At that point in time your money is gone–vaporized
     The government can offer you any rate they want—or nothing—-or negative if they chose and you are just as screwed as the customers who had their money with Sentinel, MF Global or Peregrine Financial: Just as screwed as these poor schlubs, by a government you once trusted and now gone rogue.  It will be way past ‘too late’ for you to regret your reluctance or unwillingness to get out of harm’s way but harmed you will be.
    I won’t be quite so direct as Ann Barnhardt and call a person like this stupid or on drugs. I just say that if one holds these types of invesmtments it may be unwise to continue on that course.
    Anyone with muni bonds or fed notes needs to divest themselves of these ponzi scheme cracker barrel POS investments and do so quickly.
    I know that I am preaching to the members of this choir but there are many new members to the song fest so I will continue with this position until it is not needed. That will be after the crash.
    One more thing. I have a new phrase. “You’ve just be ‘Raubed.’” Meaning that you have been take against your will by agents of the dark forces to an unknown place without being Mirandized. You have been Raubed of your freedom and rights. If you find yourself being Raubed please give voice to this.

  2. One day these pension fund idiots are going to have a light bulb go on over their head.  Suddenly they will have a thought.  GOLD.  When they move the first 1% of their assets to gold the price will go through the stratosphere. 

  3. C&P from FB side …
    In a monetary system where currency is LOANED into existence, yet an endemic paucity of willingness to BORROW emerges, the ONLY POSSIBLE recourse is to ‘negotiate’ negative current interest rates, in an attempt to make the PAST complex compounding ‘manageable’.

    DECADES of steadily falling current interest rates haven’t succeeded in ameliorating the EXPONENTIAL mathematics on which this monetary system had to be constructed. Since ‘control’ of current interest rate was the SOLITARY tool with which the ‘managers’ COULD have kept ‘the thing’ from its impending collapse, NO ONE is in control! The one tool depended upon has proven to fail at its presumed task.

    ‘The Thing’ is in control! The ‘Monster’ these ‘Frankensteins’ concocted is about to crush them ALL!

  4. Borrowing for less than nothing. Wow. Getting paid to get indebted. What a crazy idea.

    Oh wait, this has been the MO with regards to mortgages, probably also some segment of car loans, money printing (if you look at who benefits), … so why not make it the new normal.

    See that’s what you get when the lightbulbs think that credit expansion is the instrument to get GDP growth again. Credit is always most expensive for the smallest (and most ruthless generally) loans. Think microcredit, that wonderful invention of the inbreeders to skim off from the poorest  of the poorest. Or shark loans shops. Or pawn shops for that matter. Now for the mega loans no such applies. They must be cheap. It’s part of their standing. Heck it’s their business model. Like any respectable parasite they skim off the little ones the most.

    So while the derivatives’ deflation is slowly but surely starting their borrowing must be made cheaper even if its by having NIRP. Fuck those countries, fuck those people. There you have your globalists. In all their stinking glory.

    What a world we live in. 

    Best,

    R3K

  5. You know I was reading back and thinking…
     
    Actually the 2008-now-2012 crisis came about be cause the parasites were to lazy or dumb to parasitate (sp?) properly. They found it too much work to keep on skinning the little ones, they got jaded and over-confident and generally went all Jabba-the-Hut. It started around 2006 I think. That’s when the inbreds started to turn against each other because the skinning of the ordinary Joe didn’t go fast enough to satisfy their thirst and anything not involving getting off their lazy fat inbred butts was to go after other fat inbred butts.
     
    It’s an interesting way to look at these “evolvings”. Nothing happens by coincidence. And now we supposedly have the RedShield betting against the EUR while also wanting (maybe) to have a new Glass-Steagal.
     
    Power to the wise and the empathic!
     
    Greetz,
     
    R3K

  6. @AGXIIK: We’ve been “Raubed” since the end of the 1800s when silver was “demonitised” by essentially the Commonwealth “counties”.
     
    Back then they probably thought they were only “Raubing” the Indians, Chinese and Mexicans. They were probably as stupid as they are today. They just had better writing skills.
     
    Cheers,
     
    R3K

  7. mr. sprott, you are the wind beneath my wings. this is actually reminiscent of paying the mafia protection money, when you’ve stolen everything and can’t borrow another buck from broke ass people, you bust the joint out. what happens when the bond prices plummit? who is going to buy them? gee, that negative interest rate sure looks appealing. our society has been hijacked by maniacs! bonds ARE NOT A SAFE HAVEN! that’s why God created gold and silver! I have a better name than nirp, they should call them lemming bonds! yes, we’d like to announce our new lemming interest rate policy.

  8. Has anyone here heard anyone in the mainstream media talk about the difference between NIRP and ZIRP?  I haven’t.  Plenty of talk about ZIRP.  Sprott couldn’t be more on target to underscore the significance of a world now in NIRP mode.  When investors by their own choice feel the need to take a negative return just to preserve most of their capital, the system truly is broken — no exaggeration on his part.  

  9. The thing that is not addressed in the matters of ZIRP and NIRP is the effect of inflation on the dollars invested in treasuries and other bonds and gilts.  With 3-7% inflation, the investors losses are signficantly more than any interest rate income.  A negative income plus inflation is nothing less than insulting.   PERP sells to TWERP at ZIRP.  BURP.

  10. So I invest $1,000,000 in German bonds and in two years I get back $994,000?  Plus the gem of 3-7% inflation?!  Hahaha!  Yeah, sign me up.  Whose eyes can they pull this wool over?  And Germany’s one of the financially strong countries?!  Oh boy.
    Question – so does NIRP destroy currency / act in a deflationary manner, since all fiat is loaned into existence anyway? Or would it be inflationary, because the only people who would buy such an insane financial product would be central banks, would would use QE to buy/sell their less than worthless bonds?
    Just trying to wrap my head around the new “Twilight Zone” normal we’re now experiencing…  thanks.

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