Why accept a negative yield on your cash?

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Strange things are happening on global markets

Back in the depths of the Global Financial Crisis (the “GFC”…) investors in the United States were paying money for the right to hold Treasury Notes. In other words, the notes showed a negative return. How is that for strange? Why would you put your capital into cash when you know it is going to cost you money?

The answer was that some folk thought the world was so close to collapse that they just wanted some assurance that their money would actually come back to them at all…! In hindsight, it remains a strange event, when you consider that it is the United States that was looking fragile at the time.

Fast forward to today, and the New York Times tells us that bond investors in the United State have hit a new high in the world of strange events. At a recent aution of Government 5 year Treasury Bonds, the average investor paid “$105.50 for every $100 of bonds the government sold”. The NYT generally asks you to join their site to view information, so here is a Bloomberg article on the same bond issue. The yield on this issue was negative 0.55% compared to April’s aution, which yielded +0.55%.

To bring interest rates into perspective for Australians, the same Bloomberg article suggests 30 year bond yields are 3.91%, while¬†10 year yields are 2.56%. It’s hard to see anyone making money on those yields unless rates are kept very low for a very long time.

The trick to this particular auction is that the bonds on offer are “inflation linked”. That is, the return of capital in 5 years time is indexed to the change in the inflation rate over that period. So, if inflation rises enough, the investor will be rewarded for holding on in a very low interest rate environment.

How does this compare with Australia?

A quick trip to the Reserve Bank of Australia (RBA) website will show that the “small parcels facility” offers access to Australian Government bonds that are inflation linked and that these bonds yield 2.275%pa (with a maturity date of August 2015).

In other words, your “real” return after inflation is 2.275%. That is a very positive return compared to the US auction prices.

You can see from all of this just how important inflation expectations are to the pricing of cash deposits. It is currently possible to obtain 6% from online cash accounts in Australia. This is a reflection of banks wanting your cash to reduce their need to borrow capital from overseas markets. Why would you lock away your money in a 5 year bond at only 2.275% when you could get 6% online? One reason would be that you think inflation is going to be quite high. If it is then your capital will increase to reflect that fact, and you have preserved the buying power of your dollar.

What the US bond auction suggests is that many people have been worried about deflation, and they were therefore prepared to accept a low rate of return on their cash. However, the Federal Reserve moving to print money again (“quantitative easing”) should theoretically lead to inflation, which makes inflation linked bonds more attractive.

Strange times indeed.

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