August 2012
NIRP: The Financial System’s
Death Knell?
By: Eric Sprott & David Baker
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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
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
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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 shortterm 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
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
3Ibid.
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
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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)
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
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
10Ibid.
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
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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%
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.
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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. To learn more about Sprott Asset Management’s investment insights and award-winning
investment capabilities, please visit www.sprott.com.
12
Gross, William H. (August 2012) “Cult Figures”. PIMCO. Retrieved on August 18, 2012 from: https://canada.pimco.com/EN/Insights/Pages/Cult-Figures.aspx
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