Understanding Negative Yield and Inverted Yield Curve

If the interest rate is really negative, the borrower will receive the interest, rather than pay the interest rate. What is this crazy thing that is happening? And why don’t people hold their cash in hand, rather than lend at negative interest rate? And how do the banks earn money by lending at negative interest rate?

In practice, we do not need to worry for the investors who buy bonds at negative yield or for banks who loan at negative interest rate. The truth is they still make a profit.

Negative yield doesn’t mean loss

Negative yield is not similar to negative interest rate. Let’s look at Germany’s bond which is labeled as negative yield bond. The coupon rate of this bond is 0%. Basically, the bond yield column is negative, but the fact is not what you see on the table, as the investors do not invest to make foreseeable losses.

Firstly, the yield numbers are calculated based on the assumption that the investor will hold the bond till maturity. For example, if investor buys a 30-year bond with a coupon of 1.25%, at maturity he will receive a principal of $100. Furthermore, each year during the term of the bond, the investor will receive 1.25% interest as well. However, as the investor has bought the bond at a very high price of $143.58, the investor will make a loss, and on an average, the investor loses 0.21%/year. That is what a negative bond yield means.

The above analysis shows that the negative yield doesn’t mean the investor will surely make a loss. If the yield turns more negative, such as if the yield falls from -0.21% to -0.5% or further, the market price of bond will increase and be higher than $143.58. So, the investor makes a profit, rather than a loss. Hence, investors who buy bonds with negative yield will make huge profits when the yield turns more negative, meaning the price of bond increases. So the reason that investors buy bonds with negative yield is because they expect that the yield will become more negative.

Negative interest rate is just a technique

How about the news that there is a bank in Denmark which has lent out at a negative interest rate? The negative interest rate is just the title of the article. If you read the content, you will understand it differently. The borrower of DKK 250,000 at Jyske Bank will have to pay DKK 269,127 after the bank includes all charges and fees. So, the real lending interest rate is positive, not negative.

Everyone in Europe who borrows money from banks to buy houses understands that interest rate is just one of many cost types of the loan. There are many different loan products. Some loan products, which have low lending interest rate, have high fees and charges to establish the loan. In UK, the listed interest rate to borrow money to buy a house at banks is only 1%. However, after including all types of fees, the total interest rate is 2.5%.

Is inverted yield curve a big issue?

The negative bond yield does not mean investors will surely lose money when they buy the bond and the real lending interest rate is not negative as it appears. However, the truth is the lending interest rate for long term in many countries is really low. This reflects that a huge long term investment flow has poured into bonds, causing a strong increase in the price of bond and a significant decrease in the yield. This long term investment flow is also the cause of the inverted yield curve which is considered a signal for economic recession in USA.

A normal yield curve shows that the short term yield (1-2 years) is lower while the long term yield (10-30 years) is higher. The inverted yield curve happens when the long term yield is lower than the short term yield. As a result, if we deduct the long term yield to short term yield, the result will be negative. This scenario is happening in USA now. The graph shows that the difference between yield of a 10-year bond and a 2-year bond in USA is negative.

The reason that causes a long term yield to be lower than a short term yield is that most long-term investments have moved from stocks to bonds. This signal shows that investors are worrying about the future. Hence, they sell more stocks which are considered higher risk. Furthermore, some studies have revealed that recession usually happens shortly after the inverted yield curve appears. We can see this clearly on the graph.

The inverted yield curve is a symptom of a US economic disease, and we do not know if the disease is significant or not. However, if many people believe that the disease is significant, it will turn to be really significant. Currently, the inverted yield curve even can shake the confidence of people who used to be most confident and optimistic earlier.

USA has to do something to encourage people to believe in its economy, such as postpone trade war, cut interest rate or increase public expenditure. These solutions may come late given the impact of current political strategies. However, if USA encourages the economy too late, their economy may fall into a recession along with the other giant, China.