Coffee Sipping Big Board Stocks

[EZ2]

The Distortionary Power of Zero Rates


MARKETWATCH 6:41 AM ET 09/17/14


When Lehman Brothers imploded six years ago, zero interest-rate policies were an urgent part of the solution. But their persistence has caused more and more market distortions. That raises the stakes for central banks aiming for the exit.

The U.S. Federal Reserve and the Bank of England are edging in that direction--but are clearly concerned about the impact their moves may have. And the European Central Bank and Bank of Japanseem likely to be stuck around zero for an extended period yet.

The longer rates are at zero, the more they ripple through financial markets. Take the German government bond market. Nearly all of Germany's debt, out to its bond maturing in 2042, yields less than 2%.

The persistence of ultra-loose policy means Germany has been able to issue a remarkable amount of ultralow coupon debt, locking in cheap financing costs. Excluding bills and index-linked bonds, EUR67 billion of German notes now carry a zero coupon; another EUR194 billion pay coupons of 0.25-1% and a further EUR200 billion pay coupons of 1.25-2%. By the end of 2015, another EUR97 billion of debt with coupons higher than 2% will mature, and likely be refinanced at lower rates. That is a boon for Germany, but a problem for investors.

Ultralow government bond yields then influence investment-grade corporate bonds. Of the 14 senior financial and nonfinancial benchmark euro-denominated bonds sold in the week to Sept. 11, 10 had coupons of less than 2%, data from Société Générale shows. Relative valuation measures are also distorted. BASF's EUR750 million bond maturing in 2019 yields 6.1 times as much as a German government bond with a similar maturity, according to Tradeweb, which might make it sound attractive. But since the German yield is 0.09%, BASF's bond in fact pays just 0.55%. Even high-yield bonds are hardly worthy of the name except in relative terms. Bank of America Merrill Lynch's euro- denominated high-yield bond index yields a paltry 3.89%.

Markets are often capable of overshooting. But the effect of persistent zero rates, coupled with plentiful liquidity, is to force them to overshoot constantly. The result is an increasing stock of longer-dated bonds with ultralow coupons. That is a toxic combination, as these bonds are vulnerable to sharp drops in price if rates rise.

Central bankers, in loosening monetary policy, essentially aimed to boost current demand by pulling it forward from the future. Zero rates, in making cash an unpalatable asset, have done the same for asset prices: bond markets have brought forward future returns and cashed them in as capital gains. But bond prices can't rise indefinitely. And with coupons so low, there is little protection for investors against losses when policy is tightened.

Ultra-loose monetary policy has proved very good at anchoring short-term rates and expectations. But it has also led investors to discard the anchor of absolute value in favor of the siren song of relative value, storing up losses and volatility for the future. That should make central bankers nervous.

Write to Richard Barley at [e-mail]

-Richard Barley; 415-439-6400; [e-mail]

Subscribe to WSJ: http://online.wsj.com?mod=djnwires


(END) Dow Jones Newswires
09-17-140641ET
Copyright (c) 2014 Dow Jones & Company, Inc.