Another week, another country with negative bond yields. On February 4, Finland became the first European country to auction a five-year bond at a negative yield. The day before, benchmark German 10-year yields fell below their Japanese equivalents for the first time, and are currently trading at a mere 0.36 per cent – down from 1 per cent as recently as August. According to JP Morgan, some US$3.6 trillion of government bonds, accounting for more than 15 per cent of JP Morgan’s global government bond index, are now trading with a negative yield. Nearly one quarter of euro-zone sovereign debt yields less than zero. In June 2012, when investors feared that the euro zone was about to break up, Germany’s 2-year bond yield dipped below zero for the first time. Now, yields on Belgian, French, Dutch, Swedish, Austrian, Finnish, Danish and German debt are negative for maturities as long as four to six years. Even a euro-denominated corporate bond issued by Nestle, the Swiss multinational, is trading at a negative yield. Why on earth are investors paying for the privilege of lending money to governments and, more importantly, what does this say about the state of financial markets and the global economy? Even a euro-denominated corporate bond issued by Nestle, the Swiss multinational, is trading at a negative yield Part of the reason why investors are paying interest to lend money is because of the sharp increase in risk aversion over the past several months as a plethora of financial, geopolitical and country-specific threats undermine market confidence. This is causing yields on the debt of the most creditworthy countries to fall to historically low levels, forcing investors to pay for safety. Switzerland’s bonds, which are among the most creditworthy, are offering negative returns on maturities as long as nine years. The ultra-accommodative policies of central banks, moreover, are exerting significant downward pressure on bond yields as two of the world’s main monetary guardians – the Bank of Japan (BoJ) and the European Central Bank (ECB) – pursue aggressive quantitative easing (QE) programmes in which they have (or are about to) become large buyers of government debt. Yet the growing “negative universe” of bond yields stems mainly from the lacklustre growth rates and worryingly low levels of inflation – and in many cases outright deflation – that characterise much of the global economy, particularly in the ailing euro zone. Negative yields are the clearest indication that investors have lost faith in central banks’ ability to meaningfully stimulate economies. The sharp slide in oil prices, which have fallen more than 50 per cent since last June, is exacerbating fears that central banks’ ultra-loose policies are failing. Even in the US, whose economic recovery is on a much firmer footing, benchmark 10-year bond yields are currently standing just below 2 per cent – a mere 35 basis points above their level when the US Federal Reserve stunned markets in May 2013 by announcing its plans to start winding down its asset sales – despite the increasing likelihood that interest rates will start rising in June. Bond investors still question the timing of the first rate hike given the extremely subdued inflationary environment. But it’s in Europe where negative yields are far more troubling given the speed and breadth of the plunge in countries’ borrowing costs. Inflation expectations in the euro zone, although currently a tad higher than when the ECB launched its sovereign QE scheme on January 22, are even lower than in August, as measured by the so-called “five-year, five-year swap rate”, a closely scrutinised gauge of market expectations of inflation in 2020. Indeed the fact that euro zone bond yields were already at record low levels prior to the launch of QE suggests that the ECB has left it too late. Another worrying aspect of plunging bond yields is that they increase the scope for the mispricing of risk. A yield of 0.36 per cent on 10-year German paper is one thing. But a yield of just 0.63 per cent on the 10-year bonds of France, a country that is much less creditworthy and whose economy suffers from bigger structural problems, is quite another. The further yields fall, the bigger the risk of a sharper correction – particularly for southern Europe’s more vulnerable economies which are most at risk in the event of a dangerous precedent-setting Greek exit from the euro zone, a threat which is becoming more real with each passing day. Then there is always the risk that QE actually ends up working, fuelling inflation and saddling bond investors with heavy losses. But at least Europe’s economy would be better off. Nicholas Spiro is managing director of Spiro Sovereign Strategy