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behind the numbers

Stefan Klein

Imagine a world in which people are punished for saving money.

It's not so far away. In August, the yields on two-year government bonds in Germany, Denmark, Finland and Switzerland fell below zero. Negative rates may soon be coming to North America as well.

At least, that's the contention of some analysts, who say yields on two-year U.S. government bonds could fall close to zero in the weeks ahead – and might even follow their European counterparts into negative territory.

If subzero rates do come to pass, they will underscore the unusual degree of caution among investors. The world is awash in people and institutions seeking a refuge for their wealth, even if the price of safety is a small loss.

Negative rates would also spotlight the confusion on display in the markets, where ultra-low bond yields suggest a deflationary future while rising gold prices signal inflationary fears.

Part of the apparent confusion stems from the unconventional moves that central banks are making to stimulate the economy. The U.S. Federal Reserve, for instance, has instituted three rounds of "quantitative easing" to help drive down interest rates, particularly for benchmark 10-year bonds.

In a recent opinion piece in the Financial Times, Peter Fisher, the head of fixed income at Wall Street giant BlackRock, argued that the Fed's policy of holding down longer term interest rates is hurting the economy because it is reducing banks' incentive to lend and increasing the incentive for people to hoard cash.

But while the Fed may be pushing down long-term rates it has been helping to support shorter term rates through other means.

In a report this week, the research team at Pavilion Global Markets Inc. argue that the Fed has been a key player in keeping the yield on U.S. two-year bonds above zero.

Problem is, some of the Fed's support for yields is on the verge of disappearing, making zero rates or even negative ones a distinct possibility.

One factor supporting yields has been the 0.25 per cent interest that the U.S. Federal Reserve pays on excess reserves that U.S. commercial banks deposit with it. This acts as a floor for interest rates, Pavilion argues.

A second factor has been Operation Twist, a manoeuvre in which the Fed is purchasing Treasury bonds with longer maturities and selling short-dated Treasuries, such as the two-year note. This pushes down the price of the short-dated bonds. Since bond prices move in the opposite direction to yields, it also pushes up rates.

Operation Twist is set to expire at the end of this year, removing a key prop from the market.

When that happens, two-year U.S. bonds are "at risk of losing [their] anchor and looking increasingly European, i.e. negative," Pavilion concludes.

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