Negative Bond Yields and Gold by Pater Tenebrarum

Yet another gem from Pater Tenebrarum in which he clearly explains the time preference theory of interest rates.

Originary Interest vs. Bond Yields

As we have previously mentioned, the natural, or originary interest rate can never turn negative; this is so because time preference is an inviolable and universally valid category of human action. It is logically inconceivable for future goods not to be valued at a discount against present goods of the same type. Note that this has nothing to do with money – the phenomenon of interest is at its root a non-monetary phenomenon. It simply concerns the valuation of future vs. present goods. As a reminder, here is a pertinent quote by Ludwig von Mises from Human Action:

“Originary interest is not a price determined on the market by the interplay of the demand for and the supply of capital or capital goods. Its height does not depend on the extent of this demand and supply. It is rather the rate of originary interest that determines both the demand for and the supply of capital and capital goods. It determines how much of the available supply of goods is to be devoted to consumption in the immediate future and how much to provision for remoter periods of the future.

People do not save and accumulate capital because there is interest. Interest is neither the impetus to saving nor the reward or the compensation granted for abstaining from immediate consumption. It is the ratio in the mutual valuation of present goods as against future goods.

The loan market does not determine the rate of interest. It adjusts the rate of interest on loans to the rate of originary interest as manifested in the discount of future goods. Originary interest is a category of human action. It is operative in any valuation of external things and can never disappear.

If one day the state of affairs were to return which was actual at the close of the first millennium of the Christian era when people believed that the ultimate end of all earthly things mas impending, man would stop providing for future secular wants. The factors of production would in their eyes become useless and worthless. The discount of future goods as against present goods would not vanish. It would, on the contrary, increase beyond all measure.

On the other hand, the fading away of originary interest would mean that people do not care at all for want-satisfaction in nearer periods of the future. It would mean that they prefer to an apple available today, tomorrow, in one year or in ten years, two apples available in a thousand or ten thousand years.

We cannot even think of a world in which originary interest would not exist as an inexorable element in every kind of action. Whether there is or is not division of labor and social cooperation and whether society is organized on the basis of private or of public control of the means of production, originary interest is always present.

 

(emphasis added)

One example that shows why this must be so is the fact that the prices paid for productive land are finite. A piece of land producing an unchanging rent every year could not possibly have a finite price if there were no originary interest by which its future services are discounted; it would be impossible to value it. If originary interest were to disappear, land would only be bartered for other pieces of land, but would no longer be exchanged for anything else, including money.

How come then that numerous bonds are now trading at negative yields? There are several reasons for this. Central bank manipulation of interest rates is just one factor. We may assume that market participants are according a negative price premium (i.e., inflation premium) to bond yields at present, but that by itself can also not explain negative yields-to-maturity, as there is always the option of holding cash instead. In fact, superficially it seems a lot more sensible to hold cash rather than bonds with a negative yield, since one’s purchasing power is certain to increase if there is indeed an economy-wide decline in prices.

Still, there must be reasons why people buy and hold bonds sporting negative yields. Some of these are technical, and some are connected with confidence issues and/or speculation. Technically, there is for one thing the fact that banks don’t have to reserve capital for assets they hold in the form of government bonds (which according to banking regulations, are considered “risk free”). Banks are also holding inventories of bonds for the purpose of using them as collateral in repo transactions. Since government bonds are considered “risk free”, they are the type of collateral that is subject to the smallest haircuts in such transactions, which makes them desirable for this purpose. There are also market players such as insurance companies, that are practically forced by regulations to hold sizable portfolios of government bonds. These laws and regulations can be considered part and parcel of a “financial repression” scheme.

Then there are speculators who buy bonds at negative yields because they expect the trend to become even more pronounced. If e.g. a bond’s yield-to-maturity falls from minus 10 to minus 30 basis points, they will make a capital gain. This is essentially the greater fool theory of bond buying, and it probably plays a not inconsiderable role in today’s markets.

However, a major motive driving the buying of bonds with negative yields is undoubtedly also a continuing lack of confidence in the banking system. Since it has not become common yet to charge holders of current accounts (as a rule, they still sport a small, but positive yield of 5 to 10 basis points), it would be more sensible to hold cash deposits instead of government bonds. However, one would then be exposed to the counterparty risk associated with the bank.

The EU’s new bank recovery and resolution directive mandates that before government support is extended to ailing banks, all other avenues must be exhausted first – and deposit holders are legally regarded as creditors of banks. This is actually a legal absurdity, but in a fractionally reserved system, banks no longer have merely a safekeeping function for funds entrusted to them that are ostensibly available on demand. Instead, they use them for the pyramiding of credit (and the consequent creation of additional deposit money from thin air).

These risks are especially pronounced for large depositors, as events in Cyprus have shown. Since holding cash currency is impracticable for large depositors (and would also involve costs), they rather buy government debt and accept negative yields in exchange for peace of mind. In principle there is of course nothing wrong with depositors being exposed to risk if they are voluntarily putting their funds into accounts with fractionally reserved banks. There is no reason why should taxpayers should bail them out. Anyway, the fact that governments are seen as safer debtors than banks is no doubt a major reason why some large investors prefer negative yielding government bonds (as well as covered bonds with their special safety features) over bank deposits.

The entire article can be read here.

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