Italy’s negative bond yields speaks volumes about Europe’s economy

Last week, Italy, a country with the second-highest public debt burden in Europe after Greece, sold 2-year bonds at a negative yield for the first time.

Investors were willing to pay for the privilege of lending to one of the most fiscally profligate countries in the world.

While a number of European countries have auctioned bonds with even longer maturities at negative yields this year - Germany sold five-year debt at a negative yield in February while Switzerland sold 10-year paper at a negative yield in April, the first time a government made investors pay to lend to it for such a long period - Italy is the unlikeliest member of the negative yield club.

This, after all, was the country that was once the focal point of investor anxiety about the eurozone. In November 2011, Italy’s 2-year yield stood at a crippling 7 per cent amid fears that the country may need a full-blown bail-out given its high level of indebtedness and persistent lack of growth. Indeed 2-year yields were still trading near 5 per cent in May 2012.

Since then, while Italy’s dysfunctional political scene has stabilised and the economy has at least stopped contracting, growth is extremely weak and Italy’s public debt burden continues to rise.

So how is it possible that investors are paying the Italian government to lend to it?

For the simplest answer to this question, look no further than the weak state of the global economy - further endangered by the sharp slowdown in emerging markets (EMs), in particular the powerful disinflationary forces from China - and the distortive effects of the ultra-accommodative policies of the world’s leading central banks.

Bond investors are betting on the likelihood that growth and inflation around the world will remain weak for the foreseeable future.

This is particularly the case in Europe.

According to data from Bloomberg, the average yield on an index of eurozone government bonds due within five years has just turned negative for the first time. Nearly US$2 trillion of eurozone government debt is yielding less than zero despite signs earlier this year that Europe’s nascent recovery was gaining momentum.

Yet having returned to positive territory in April after several months of deflation, the eurozone’s inflation rate once again turned negative in September and was flat last month. While this is mainly due to the renewed decline in oil prices, core inflation has been stuck near 1 per cent - significantly below the European Central Bank’s 2 per cent target - for the last six months.

Expectations that the ECB will be forced to provide further monetary stimulus is putting downward pressure on Europe’s bond yields, with the yield on German 2-year bonds falling a further 10 basis points since early September to -0.32 per cent.

One of the measures which Mario Draghi, ECB president, hinted at at the central bank’s last policy meeting on October 22 was a further cut in the ECB’s deposit rate (the rate charged on banks’ reserves parked in the central bank’s coffers) which already stands at -0.2 per cent.

Another reduction in the deposit rate would weaken the euro and push Europe’s bond yields down further - particularly if the Fed hikes rates at its next policy meeting on December 15-16, accentuating the divergence between European and US monetary policy.

The big question, however, is whether further monetary stimulus - and in particular negative bond yields - is helping solve Europe’s underlying problems.

Quite aside from the distortive effects of QE on financial markets – investor sentiment has become detached from economic fundamentals, as Italy’s negative bond yields show all too well - the collapse in interest rates has made it extremely difficult for pension funds to meet their return targets, leading to a surge in pension liabilities and contributing to higher debt burdens across the EU.

More worryingly, the ECB is not getting sufficient support from national governments, many of whom have been reluctant to implement the necessary economic and institutional reforms needed to turn the eurozone’s shaky monetary union into a more secure political and economic one.

Still, with the euro having already fallen 5.5 per cent against the dollar since mid-October because of heightened expectations that the Fed will hike rates next month - the single currency fell more than 1 per cent on Wednesday after hawkish comments from Fed chair Janet Yellen - the pressure on the ECB to provide further stimulus may yet diminish if the dollar continues to strengthen.

Yet if the ECB doesn’t act next month, the euro could start rising again, putting further downward pressure on inflation and keeping bond yields in negative territory.

With Italy’s 2-year yield having dropped nearly 20 basis points since late August to 0 per cent, it’s clear investors are betting on further stimulus, for good or ill.

Nicholas Spiro is managing director of Spiro Sovereign Strategy