, , ,

This is truly remarkable: The U.S. fixed-income market has a entered a negative interest rate environment. I thought a zero percent interest rate was a structural lower bound. Incorrect!

W00T!! W00T!! W00T!!!

Something I never in my wildest dreams thought I would see in my lifetime.

Debt sales highlight abnormal conditions: The abnormal state of the credit markets came into focus as the US Treasury sold bonds with negative interest rates for the first time and Goldman Sachs prepared to issue its first 50-year debt deal. Both developments… highlighted the difficult choices facing investors at a time when interest rates are at historical lows and the Federal Reserve is moving towards more asset purchases aimed at boosting the economy and staving off deflation. Investors who believe the Fed will succeed in its efforts – which would lead to higher inflation – accepted a yield of minus 0.55 per cent on $10 billion of Treasury Inflation Protected Securities…. At the same time, retail investors looking for higher yields in the current low interest-rate environment were targeted by Goldman, which prepared to sell $250m of 50-year bonds that are expected to pay interest of up to 6.25 per cent. —25 October 2010

Under normal market conditions, interest rates are greater than or equal to zero. This means that the borrower is paying the lender (in the form of interest) for the benefit of temporarily using the lender’s funds. What are the implications of a negative interest rate? Is the borrower being paid by the lender?

In the context of yesterday’s Federal Reserve Bank activity, the U.S. Treasury is the borrower, issuing government debt in exchange for cash from the bond buyers, who are the lenders. In a normal interest-rate environment, the Treasury pays interest to buyers of its T-bills, notes and bonds. Negative (effective) interest rates of 0.55%, however, imply that the lenders i.e. purchasers of U.S. debt obligations, are effectively paying the borrower, the U.S. Treasury! At first glance, 0.55% appears to be merely a slight premium. In terms of U.S. government cash flow, it is insignificant. However, in absolute terms, this is equivalent to a lender saying,

“Here! I’ll give you a loan, free of charge. In fact, I will pay YOU $55 million AND let you borrow $10 billion of my money too!”

What was the economic incentive for lenders (bond buyers) at yesterday’s auction? Why would anyone lend money if there were no profits? Were the lenders actually accepting an obligation to pay interest to the borrower? There are probably many answers. The most obvious to me is the expectation that conditions will reverse over the course of time. In fact, encouragement of such inflationary expectations is critical to the success of the Fed’s policy of quantitative easing.

Yesterday’s other market anomaly, Goldman’s ultra-long maturity bond issue, now follows logically. There would be little incentive to purchase short-term paper with negative rates of return. Investors will be more receptive to long-term debt obligations, and be more likely to accept the risk. Thus the motivation for Goldman Sach’s issuance of 50-year maturity bonds, another signal of abnormal market conditions.