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Today, the European Central Bank announced that it was cutting interest rates. It also said that it was open to negative deposit rates.
We are witnessing nothing less than the metastasis of monetary cancer. A falling interest rate causes the destruction of capital.
Here is a picture of the rate falling from over 4% to under 2% in 5 years.
This is the part most people understand. Rates have been falling for years (decades). What most people, other than bond traders, aren’t thinking about is below. Look at the price of the bond (continuous futures).
The price has risen around 117 (ignoring the dip) in 2008 to 147 today, a gain of about 26%. This is the capital gain to the bond buyer. Where does it come from? Thin air?
It comes from the capital account of the bond seller. To the seller, the liquidation value of each euro of debt–and the net present value of the liability–has risen 26%. This is in addition to the increase in the number of euros of debt.
Rates cannot keep falling forever. Something is going to break.
[Images are courtesy of Alex Manzara at TJM Brokerage]
Yes, it’s junk trading above par with junk.
Rationalise that.
“This is the capital gain to the bond buyer. Where does it come from? Thin air?”
Pardon my ignorance but I used to think it was coming from the destructed capital of the savers who have been receiving the sub-zero real rates (stealth). If that’s not the case, then where else does that destructed capital go? It has to take some sort of monetary form somewhere.
steevan: the saver is not losing his capital, he is forced to accept a low rate of return. At last not due to changes in interest rates; he does, of course, lose as the value of paper money falls.