Negative rates could shake up the financial system

Falls in European interest rates into negative territory could profoundly affect the workings of the financial system and there is little chance of benchmark borrowing costs rising in the year ahead, top investment managers and strategists have warned.

Yields, which move inversely with prices, have this year dropped below zero on a rapidly expanding range of European governments' bonds — and even some corporate bonds. The declines, which are driven by the European Central Bank's "quantitative easing", mean historically low borrowing costs. But senior finance experts interviewed by the Financial Times saw worrying side-effects.

"This could be the makings of a completely new environment for global bond markets," said Andrew Milligan, head of global strategy at Standard Life Investments, at the FT's debt capital markets conference in London. "If it actually becomes permanent...There could be some very significant capital flows."

“It has a huge impact on a lot of simple things like pension funds and insurance companies, and how their whole model works,” said Henry Cooke, executive director at Gryphon Capital Investments. “It is putting them under a lot of pressure...and when people are put under a lot of pressure, they take a lot more risk.”

Negative interest rates mean investors, in effect, pay to lend their money. Jerome Booth, former head of research at Ashmore Group, said: "It is perfectly acceptable for a government to try to get a negative yield — it sounds a good deal. The problem is: why would investors do it?"

The ECB’s action has forced countermoves by central banks outside the eurozone. Danish and Swedish five-year bond yields ended last week at minus 0.48 per cent and minus 0.04 per cent.

Neil Williams, group chief economist at Hermes Investment Management, said: "It smacks, surely, of the first signs of what you could call a currency war. Not all central banks can push their currency down sufficiently to stoke up demand...I am not so sure it is the solution."

Some $2tn of European government bonds over more than one year’s maturity have negative yields, according to JPMorgan.

Yields are also negative on Swiss government bonds, and earlier this month turned negative on some euro-denominated debt issued by Nestlé, the Swiss food manufacturer.

Finance experts did not have high expectations of an early end to the era of ultra-low interest rates in continental Europe. German 10-year yields ended Friday at 0.34 per cent, compared with 0.54 per cent at the start of the year. “Near zero for the 10-year yield for Germany is not unlikely,” said Pascal Duval, chief executive for Europe at Russell Investments.

The investment specialists expressed concern on whether QE would boost economic growth in Europe, but argued it was needed to fight deflation threats. “It creates the best opportunity for a good outcome in Europe,” said Martin Reeves, head of global high yield at Legal & General Investments.

However, UK and US market borrowing costs could increase this year on the back of possible interest rate rises by the Federal Reserve and Bank of England, the experts reckoned. Mr Reeves said wage inflation in the US and UK would "push up government bond yields around the world — and probably quicker than people think because everyone has got so bearish." – Copyright The Financial Times Limited 2015