Expert Commentary

The Lead Boots of Deflation

The glacial forces of deflation are showing up again via the growth in negative yielding debt.

You know that dream? The one where you're trying to run away from something (mine used to be Frankenstein) but your legs are stuck in gloopy mud, or your boots are filled with lead? Even though you try with all your might to get away, you just can't seem to move. Central bankers around the world might be tossing and turning at night with that dream in their heads. The thing they can't get away from? Deflation.

That is, their own definition of deflation, which is falling consumer prices. Ever since the financial crisis a decade ago, the entire focus of central banks has been to stave off falling prices, something they see as bad for the economy. Try as they might, though, consumer and producer prices have simply not accelerated in the way they want. Prices of financial assets have, but that has led to a massive gap between the haves and have-nots, putting incredible strain on societies' cohesion. (Ah, the unintended consequences of central bank policy-- the true Frankenstein monster!)

Price inflation expectations, as measured by breakeven rates in the bond market, have been under pressure. 5-year breakevens in the U.S. bond market got to nearly 2.2% in May 2018, but collapsed to below 1.50% by the start of this year, and currently languish around 1.82%. Europe has seen a similar dynamic. The clear message from market pricing is that inflation expectations are coming down.

That is also evident by the recent collapse in bond yields around the planet. The chart below shows the amount of debt outstanding in the world that has a negative yield. It has just surpassed the $10 trillion mark for the first time since 2017. According to this dataset, the high was just over $12 trillion in 2016.

When someone invests in a bond that has a negative yield, intending to hold until maturity, they are guaranteeing a loss. The fact that there are obviously many people who are prepared to do this tells us something about psychology. It could be that investors in negative yielding bonds don't see any other option if they want to keep their money "safe" in sovereign bonds. But it could also imply that people are prepared to accept a guaranteed reduction in their capital, if they think that things they could buy with that capital will get cheaper. That is a deflationary mindset. And when a deflationary mindset sets in, it's very difficult to get rid of it. Just take a wander down Shinjuku in Tokyo and ask a few Japanese.

Bloomberg Barclays Global Aggregate Negative Yielding Debt Market Value