Some government bonds are now being quoted with negative yields. Taking an extreme example, Swiss government bonds are now being quoted with negative yields for all maturities up to 10 years. This prompts the question: Who, in their right mind, would pay a government for the ‘privilege’ of lending the government money?

The zero or negative bond yields are almost certainly related in part to the desire by large cash-holders to ensure a return of cash, even if doing so guarantees a small nominal loss. By way of further explanation, if you have $100K of cash to park somewhere you can put it in an insured bank deposit and be guaranteed of getting your money back, but what do you do if you have $1B of cash? If you put this money into a bank account then only a trivial portion will be covered by the government’s deposit insurance, meaning that the failure of the bank could result in a substantial portion of your money being wiped out. To avoid the risk of a large loss due to bank failure it might seem reasonable for you to lend the money to the government at a yield that is certain to result in a small loss. In this case, the small loss stemming from the negative yield on your bond investment is a form of insurance that guarantees the return of almost all of your money.

In other words, at a time when “inflation” risk is perceived to be low and there are concerns about the safety of commercial banks, it could make sense for a large holder of cash to lend the money to the government at a small negative yield.

That being said, it’s important to remember that we aren’t really dealing with 0% or negative bond yields, we are dealing with 0% or negative yields to maturity. The bond yields themselves are still positive.

To further explain, consider the simple hypothetical case of a 1-year bond with par value of $100 that pays interest of $2 at the end of the 1-year duration. If the bond is trading at its par value then both the yield and the yield to maturity (YTM) will be 2%, but both yields will be something other than 2% when the bond’s price deviates from $100. For example, if the bond’s price rises to $103 then the yield falls to 1.94% ($2/$103) and the YTM falls to negative 0.97%. The YTM in this example takes into account the fact that if the bond is held until maturity then the buyer of the bond at $103 will receive a $2 interest payment plus a $100 principle payment, or a total return of $102 versus an outlay of $103. The $1 loss on the $103 investment equates to a return of negative 0.97%.

An implication is that someone who doesn’t plan to hold until maturity can still make a profit on a bond with a negative YTM. For example, someone who buys a Swiss government bond with a YTM of negative 0.1% today will have the opportunity of selling at a profit if the YTM subsequently falls to negative 0.2%. The current ridiculous valuations of some government bonds could therefore be partly explained by the belief that valuations will become even more ridiculous in the future, thus enabling today’s buyers to exit at a profit.

That is, in addition to the willingness to accept a small loss for a guarantee that almost all of the money will be returned, the “greater fool theory” could be at work in the government bond market. In this regard, a government bond having a negative YTM is not that different from an internet stock with no revenue being assigned a multi-hundred-million-dollar valuation based on “eyeballs”. It’s just another in a long line of examples of the madness of crowds, a madness that is often rooted in central bank policy.

In a shot out of the blue, on Thursday 15th January the Swiss National Bank (SNB) suddenly removed the Swiss-Franc/Euro cap that was put in place in August of 2011. Due to the cap that was imposed by the SNB way back then, the SF has effectively been pegged to the euro over the past three-and-a-bit years. Since the SF was a chronically stronger currency than the euro, maintaining this peg forced the SNB to massively expand its balance sheet by monetising huge quantities of euro-denominated bonds.

It seems that the SNB belatedly came to see that continuing to peg the SF to the euro created the risk that the SF would become excessively weak and unstable. The sensible, but surprising, decision was therefore made to eliminate the peg. A result was a gigantic single-day surge in the SF relative to all other currencies, not just the euro. For example, the following chart shows that the SF gained almost 20% relative to the US$ on Thursday. As far as we know, this is the biggest single-day move by a major currency in at least 50 years.

It should be noted, however, that the SNB’s shift to a more prudent monetary stance was only half-hearted, because at the same time as it announced the removal of the SF/euro cap it also announced that official 3-month interest rates would be set between NEGATIVE 0.25% and NEGATIVE 1.25%. In effect, the SNB is saying that it will pay speculators to short the SF.

In early October of last year I published an article (an excerpt from a TSI commentary) dealing with why the US$ was rallying. The point I tried to get across in this article was that rather than the main cause of the euro’s weakness — and the Dollar Index’s associated strength — being the fear that the ECB was going to stimulate (meaning: inflate the money supply) more aggressively, the main cause was the fear that the ECB would be unable to stimulate aggressively enough to sustain the bull markets in European stocks and bonds.

The argument I made at that time was based on the strong positive correlation over many years between the euro and the performance of European equities relative to US equities (as indicated by the VGK/SPX ratio). Specifically, the fact that relative strength in European equities invariably went with a rising euro and relative weakness in European equities invariably went with a falling euro implied that bullish influences on European equities would also tend to be bullish for the euro. At a time when inflation fears are low, nothing is more bullish for the broad stock market than monetary inflation.

Consequently, it was clear to me then, and it is just as clear to me now, that if the market starts to believe that the ECB will have greater ‘success’ in its efforts to pump more money, then the euro will rally on the back of relative strength in European equities.

Here are charts (one long-term and one short-term) that illustrate the relationship between currency performance and relative equity performance that I’m talking about.

Here is a slightly-modified excerpt from a commentary posted at TSI last week:

Following the lead of Doug Kass I am now going to present a list of financial-market surprises for the year ahead. These are events/developments that are expected by very few market participants and commentators, but in my view have either a greater than 50% chance of happening (in the cases of surprises 1 to 6) or at least a high-enough probability of happening to be worthy of serious consideration (in the cases of surprises 7 to 9). Here’s the list:

1) The Fed continues to make noises about ‘normalising’ monetary policy, but ends up doing almost nothing. At most, there is a single 0.25% rate hike. One reason is the fear that economic weakness elsewhere in the world, primarily the euro-zone, will weigh on the US economy. Another reason is the absence of an obvious “price inflation” problem. A third reason is the Fed’s unwavering commitment to the absurd Keynesian idea that an economy can be strengthened by punishing savers.

2) US Treasury yields defy the majority view by ending the year flat-to-lower. More specifically, the 30-year T-Bond yield is roughly unchanged over the course of the year, but yields decline in the middle and at the short end of the curve. Of all the Treasury securities, the 5-year T-Note experiences the largest decline in yield as traders belatedly realise that the Fed will not be taking any significant steps towards ‘policy normalisation’ during 2015 or 2016.

3) Gold defies the numerous calls for a decline to US$1000 or lower. It does no worse than test its 2014 low during the first half of the year and commences a major upward trend by the middle of the year. As is always the case, gold’s bullish trend is driven by declining confidence in central banking and rising concern about ‘tail risk’. A related surprise is that the gold-mining indices outperform gold bullion.

4) Despite superficially lousy fundamentals, concerns about future supply reductions/disruptions cause oil to commence a cyclical bull market during the second half of the year.

5) The recovery in the oil price comes too late to prevent widespread debt default and bankruptcy within the US oil-and-gas industry. Due to the many knock-on effects of large-scale retrenchment within this industry, including slowdowns in all the businesses that indirectly benefited from the flood of money channeled into the drilling of shale deposits, it becomes clear that the collapse in the oil price was a net-negative for the US economy.

6) The Yen ends 2015 more than 10% higher than it ended 2014 as the Yen supply continues to grow at a comparatively slow annualised rate of less than 5% and carry-traders exit their positions in reaction to increasing risk aversion.

7) The S&P500 never closes above its December-2014 peak and generally works its way lower throughout the year.

8) The Russian currency (the Ruble) and stock market (RSX) bottom-out during the first half of the year and end 2015 with net gains.

9) The copper price trades below US$2.30/pound during the first half of the year within the context of a deflation scare and downwardly-revised forecasts for global economic growth.