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Imagine a world where you have to pay to loan the government money. Sound strange? It's already the reality in Germany, where yields on government bonds, including those maturing as far away as eight years from now, have fallen into negative territory. The 10-year Bund, the German equivalent of a U.S. Treasury and a benchmark for long-term interest rates in Europe, is just a hair away from zero. If (or when) long-term German rates go negative, expect to see headlines about the the global economy's strange new post-financial-crisis rules.
How are negative rates possible? And why would anyone invest in something that they knew would be unprofitable? Before we dive into those questions, here's some background on the whole situation.
Bonds go negative when they get expensive
On the most basic level, Bunds, like Treasuries, are essentially a cash IOU from the government that needs to be paid back in a certain timespan. Since government bonds from solid countries like Germany are all but certain to be paid back, investors snap them up when they're concerned the economy will be sluggish and don't see any better investment opportunities.
Europe's economy has been stalled for a while, and prospects are dim. That drives up the price of bonds (their current market value), which has an inverse relationship on their yields (their rate of return over time). Meanwhile, the European Central Bank (Europe's version of the Federal Reserve) has been trying to stimulate the economy with "quantitative easing," a bond buying program that puts further downward pressure on rates. Over the past year, yields on 10-year German debt have fallen from roughly 1.5% to 0.07%.
Why would investors pay to lose money?
The idea that someone would pay for negative-returning asset might seem crazy, but it's not quite as strange as it sounds. Investors are always expected to accept lower returns for safer assets. Cash, the safest asset of all, often loses value over time due to inflation.
But inflation is not a big worry for Europeans right now. In fact, they are more worried about deflation, or falling prices. If Europe has low inflation or deflation, the real yield on Bunds won't be as low—and could even be positive while nominal rates are negative.
It's worth noting that sub-zero bond yields aren't exclusive to Germany. In the U.S., the inflation-protected Treasury bonds (called TIPS) also went just slightly negative last week. So real, inflation-adjusted 10-year yields are near zero in the U.S. too. The demand for safe money is a global thing.
What all this means for you
Germany's oddball bond market isn't just interesting in an abstract sort of way. It's also very significant for American investors. First of all, lower yields on European investments send some investors looking for other assets that have a higher return—which means they've been sending capital to the U.S., where nominal rates are higher.
International demands for American bonds is one reason the U.S. dollar has become so strong in recent months. A strong dollar is good for your travel budget, but it's been putting a drag on the economy by making American exports more expensive.
Low European yields are also keeping a lid on how high U.S. interest rates can go. The 1.8% yield on regular 10-year Treasuries is pretty attractive compared with German and other sovereign bonds, so that's helped keep global demand for Treasuries high.
Falling Treasury yields mean rising bond prices, which has been good to the total return of bond mutual funds over the past year or so. But anyone relying on bond yields for a steady stream of income is not going to be happy with the direction things are headed. Broadly diversified bond funds are paying income of only 2% or so. If you are putting your savings in cash, of course, you've been earning even less.
House hunters, on the other hand, might be quite pleased. Mortgage rates are generally tied to the 10-year Treasury, so if yields stay low, so will the price of owning a home. The same is loosely true with credit card interest rates.
In short, keep your eye on those Bunds. In global economy, what happens in Europe doesn't stay in Europe. Not for a second.