A feature of these times has been the way that the initial cuts in interest-rates undertaken by central banks were some years later followed by a second wave especially for countries in and neighbouring the Euro area. This plunged many of them into the icy cold waters of negative interest-rates. Regular readers of this blog will not be surprised to see rumours of their being another member of this club as its central bank Governor is a “dedicated follower of fashion”. From the Financial Times and the emphasis is mine.
UK government bonds are enjoying the best start to the year since 2001 as a succession of poor economic data releases chip away at confidence in the recovery, raising market speculation that the UK may need to cut interest rates this year.
I have to confess I did wonder if they would point out that I have been warning about this for a couple of years now but I guess that would be embarrassing for all the “experts” they have quoted and given airtime and space to over that period. However more importantly there is another consequence of this.
In early Monday trade, the yield on 10-year Gilts was at 1.37 per cent, just above February’s record low
That is for someone who has followed such things for over two decades is simply extraordinary. There was a time I recall the long Gilt yielding 15% although back then the maturity was more like 15/20 years than the modern 10. But as we have discussed on here before this poses all sorts of questions for the long-term business models of pensions and insurance companies. It is hard not to think of the pensions illustration posted in the comments here by Andy Z with an illustration of -3% per annum or losses and quite considerable ones at that.
Negative Bond Yields in the Euro area
It is not only official interest-rates that are negative here as the 80 billion Euros a month of ECB (European Central Bank) bond buying has driven many bond yields and longer term interest-rates negative as well. Bloomberg puts it like this.
The driving force behind the bond binge is the growing universe of negative-yielding securities, which has expanded above $9 trillion since the European Central Bank and Bank of Japan cut interest rates below zero.
The German bond market has negative yields out to the nine-year maturity and if we switch to fast growing Ireland I note that the ten-year yield of 0.77% looks a bit thin to say the least compared to annual economic growth of 7.8% (GDP) or 5.7% (GNP). However there has been another consequence as the ECB starts to chomp away on Corporate Bonds too.
What could go wrong? Well at least part of that is what I will look at next. Although of course the obvious issue is simply one of mispricing rather like the AAA rated Mortgage Backed Securities which did so much to get us into this mess.
The problems of pension funds and insurance companies
The President of the Bundesanstalt für Finanzdienstleistungsaufsicht weighed in on the subject last week and with a name like that it has to be Germany, fortunately it shortens to BaFin.
Institutions which primarily based their business models on interest income and maturity transformation were having increasing difficulty generating sufficient income in the long term.
If we look at occupational pension funds this was stated.
However,Pensionskassen (occupational pension schemes) were suffering even more than life insurers from the low interest rates. In individual cases, they might soon be unable to provide their benefits in full using their own resources.
So they will soon be unable to pay out the benefits their pensioners expect. Many of them will no doubt consider these to have been guaranteed. Is “using their own resources” a cry for help and from who exactly? With Mario Draghi setting out ECB policy into the next decade and implying negative interest-rates and yields then there is little if any sign of relief on the horizon.
Actually there is an excellent reply to this in the comments section of the FT.
Wasn’t the Greek the one wasting money into a crazy pension system ? Ah, no: it’s the German. LOL. ( Musso)
Actually though the Germans are not alone.
Bafin’s comments come just two weeks after the head of France’s largest public pension fund warned many retirement funds in Europe will “implode” if the ECB’s low interest rate policy continues.
Probably not the sort of implosion seen at Old Trafford or indeed St. James Park yesterday but nonetheless not something to help pensioners sleep at night. I have written before about issues with the Dutch pension system ( there were cuts in 2013 if I recall correctly) and they too are in this club.
ABP, Europe’s largest retirement fund, which provides pensions for one-sixth of the Dutch population, also said last month there is a “distinct possibility” of benefits being cut in 2017 due to declining interest rates.
According to Exactica ABP is in what Taylor Swift would call “trouble,trouble,trouble….”
By law, a pension fund must have a coverage ratio of 105%, meaning its assets outweigh its obligations by 5%. However, that of the massive civil service fund ABP has now gone down to 90.4%, a drop of seven percentage points since the end of 2015.
That poses a few questions as after all is not the QE of the ECB supposed to be driving asset prices higher. If so how are they falling? After all bond prices are in many cases as high as they have ever been.
There is a reply to this saying “Deal with it” as I wonder if it was written by Mario Draghi.
Never believe anything until it is officially denied
We have learnt that one of the signals of a serious problem is an official denial of it and here it is from mouth of Mario Draghi.
It’s pretty evident that pension funds and insurance companies and other actors are significantly affected by the low-level of interest rates. By the way, I would urge all the actors in this sector to resist the temptation to blame low interest rates as the cause of everything that went wrong and had been going wrong for years with this sector.
So Mario was shifting the blame along the lines of “It’s not me, It’s you” from Lilly Allen. I do note that he went on to confess both borrowing from the future and can-kicking.
one should keep in mind that they also realised substantial capital gains on the bonds that we are buying, because some of them are amongst the main sellers,
These asset prices seem to be simultaneously high and low! Of course there are other assets excluding bonds but QE was supposed to be boosting them too. Oh and his excuse that in the US pension funds have seen zero rates for longer needed to be challenged by the fact that they have not seen negative ones yet.
Insurance Companies too
These are also being affected by negative yields and interest-rates although Bafin seems to have confused itself on this subject.
the low level of interest rates was weighing on life insurers, but said that BaFin could not currently confirm that undertakings, even smaller ones, were increasingly turning to risky assets to be able to fulfil their guarantee commitments.
I think we all can answer that one for them!
Comment
We are now seeing the consequences of the “more,more,more” policies of the central banks as they find themselves reaching a future that is not as good as promised or hoped. If we look at the Euro area it has just had a better start of 2016 (0.5% GDP growth) but sadly recent years have disappointed. Of course much of the fault lies with the politicians who have pretty much left economic policy to the ECB which has often found itself to be the only player in town. But like a one club golfer there are consequent problems.
Pretty much every long-term business model in the arena of finance is broken right now as they rely on a level of yields that no longer exists. Actually we find ourselves wonder if even the longest dated bonds may have their own outbreak of negativity as Japan on Thursday issued a 30 year bond offering only 0.33%. Great for the Japanese taxpayer but dreadful for the buyer in my view. Is yet another bailout on the way?
Meanwhile I note in the BaFin report confirmation of the banks operating for the benefit of the banks in spite of all the supposed new regulation.
BaFin wanted to find out whether banks and savings banks were systematically disadvantaging customers by unreasonably delaying the passing along of interest rate changes on consumer loans to them.
Oh and American readers may not be quite as comfortable as they might have thought as perhaps Mario Draghi will be right.
I would not completely rule out the use of negative interest rates in some future very adverse scenario, ( a letter to a Congressman from Janet Yellen)
I thought they were supposed to be illegal in the US?
Notayesmanseconomics's Blog 
Perhaps the CBs will use helicopter money to top up the pension funds – after all, pensioners have a high marginal propensity to consume. Isn’t it time (again) for a bit of Tears for Fears “Mad World”?
Joss
Does anyone know the percentage of the economy that is made up of the ” grey pound “? Shrinking retirement income may have a disproportionate effect on growth.
Don’t know if you say that in jest but I genuinely believe that a time will come when Government does exactly that! Except, it will be in a clandestine, indirect round about kind of way, like “a riddle, wrapped in a mystery inside an enigma”…..
Are you aware of the serious implications for the housing market of ever-dwindling pensions?
I know that the dwellings of most pensioners are bought and paid for, but if the over-50s have to commit more and more of their earnings to their pension fund, they won’t have it to lend to their offspring.
http://www.dailymail.co.uk/news/article-3570953/The-Bank-Mum-Dad-funds-HALF-savings-average-London-households-lends-time-buyers-10-mortgage-lender-study-reveals.html
damm, so plan B isnt gonna work
those pesky pensioners will eat all their capital instead of giving to the BANKS via their children
got help you if your parents had more than one child anyways
fobin
Hi Shaun
Great article as always. The law of unintended consequences always rears it ugly head.
I was wondering if you could clarify something please. Are the pension funds described above defined benefit funds?
thanks
Hi Anteos and thanks
The German pensions discussed by BaFin are described as occupational pension schemes so yes they are definitely defined benefit. The Dutch ABP pension system is on the same model although it switched like quite a few schemes in the UK to average salary entitlement.
hello shaun,
the plan was for the older gen not to have pension funds but to cash them in and buy hiuses for rent income
thus when the pensions industry collapses , which it must do given the current restraints, they will be better off or atleast an easy target for blame whilst HMG and the Banks walk off with the loot
its becoming more clear we are run by bankrupted Banks !
Forbin
Hi Forbin
You know my views on the banks and banking system. After all why has the US Fed some US $1.2 billion of swap lines to European banks via the ECB? Someone has trouble getting US $ liquidity in a recovery phase…..
Perhaps the banking system will eat everything before finally collapsing! In the UK we keep being told of the benefits but end up seeing this. From the BBC.
“HSBC has announced it will transfer 840 IT jobs from the UK to other sites around the world, with almost 600 posts in Sheffield being axed.”
I seem to remember the government ordering pension funds to buy bonds as equities were too dangerous.
Was this applied across the EU?
If so, governments are making pension funds buy at negative yields.
This must rate as one of the best scams ever.
Have the great and the good gone utterly mad, or have they always been mad.
PS
Perhaps we are worrying about nothing, as per David Cameron, war will break out if we vote to leave the EU and who will care about pensions then?
Also the BoE said interest rates would rise if we left the EU.
So the obvious solution to the pension problem is to vote for Brexit; less pensioners, as they are killed by war and higher interest rates to pay for the remaining ones. (Sarcasm for those hard of thinking)
Nick
Hi Nick
If you mean the Minimum Funding Requirement or MFR that was brought into effect in 1997 and had this effect as you suggest.
“it appears to have created some extra demand in the long end of the gilts
market, which may have contributed to the depression of yields ”
I recall believing at the time that it was designed to create extra demand in the UK Gilt market. Since then there have been various other crackpot valuation schemes!
The European model always was for higher bond and lower equity holdings than in the UK so I would expect there to have been fewer changes there. The irony is that of course the government bond holdings have seen large capital gains in recent times.
There is a brilliant letter from the Duke of Wellington about one of his generals along the lines of madness…
LOL the EU go to war ? It is only France with nukes, and I suspect they’d celebrate Brexit not fight it ….
I believe that pestilence and famine will also rear their heads in case of Brexit. Buy your shares in undertakers now.
Hi Shaun, Uncertainty about the security of your pension is very damaging to confidence and consequently spending power, especially if benefits in payment are reduced. A financial setback when you are 30 is one thing but the last thing you need later in life. Having worked in the pension industry a while back I’ve looked with alarm at the diminishing returns for many years even prior to the with-profits scandal. No wonder people I know see buy to let as an important part of their future income and so far it’s worked out really well for them.
I started a pension (money purchase) in the late 80s and the illustrations of the benefits at retirement showed the fund growing at approx 13% pa. They used to include projections for several interest rates that being the highest!!
Later (in the mid 90s) I worked in a large insurance company in the pension review where people had been mis-sold pensions on the basis of these wild predictions and many had left their safe final salary company pension (where the risk is borne by the employer) for a supposedly better one from an insurance company (where the risk is borne by the pension holder). It was an eye-opener. Most of the policy holders were paid a lump sum to put them back into the position they would have been in if they hadn’t left their company pension scheme.
Since then (for as long as I can remember) annuity rates have fallen so that now a pension is probably little better than any other form of saving eg ISA etc. If rates go negative…….well…..
As for buy-to-let the tide seems to be turning there now too.
There do seem to be some practical restrictions on negative rates. As i understand it so far no bond has a negative coupon, just that the redemption yield is negative after allowing for coupons (if any) plus capital loss. If rates were to be driven more deeply negative could issuers look to have the bond holders pay a coupon to the issuing company or government. Is it conceivable the bond holder could then be pursued for failing to pay interest to the organisation who has borrowed their money (leaving aside that the organisation would only tend to know the identity of the bondholder’s broker account not the bondholder themselves). Similarly at the retail level if an individual can borrow at negative rates could they not just borrow an infinite amount since the principal could be stored as cash and they return the required smaller amount at the end of the loan?
” Pretty much every long-term business model in the arena of finance is broken right now…”
Well , thanks very much Shaun. There’s nothing like being forced to faced reality – with a jolt.
Shaun,
The one thing that puzzles me (well, one among many, actually) is why people still save for a pension (except maybe through an ISA). When I asked my pension firm this question, they waffled on about tax advantages and matching funding from my employer. Not a word was said about what I might get out of it. I then received a pension statement from a different firm and, basically, they could pay the income offered by putting it in a current account and running it down over 30 years. Unbelievable, but at least one thing shines out as a certainty in these difficult times – namely, their fees for doing nothing.
To me, the system is:
1. The government gives us breaks to save for a pension;
2. The pension funds charge us huge fees;
3. The pension funds buy gilts.
It is like being taxed again as far as I am concerned.
“the obvious issue is simply one of mispricing rather like the AAA rated Mortgage Backed Securities which did so much to get us into this mess”
I hold by the view (like Michael Pettis) that it didn’t have to be sub prime mortgages – it could have been anything. Indeed, before it, it could have been borrowing to buy tech companies. The main reason for the rise in debt levels is the imbalanced international trading system.
So, your point is even better – too high a debt can create rising prices and panic buying and ‘mispricing’, which is revealed when over leverage by some buyers is forced to go into reverse.
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