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The LIBOR scandal
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The rotten heart of finance
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A scandal over key interest rates is about to go global
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Jul 7th 2012
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THE most memorable incidents in earth-changing events are sometimes the most banal. In the rapidly spreading scandal of LIBOR (the London inter-bank offered rate) it is the very everydayness with which bank traders set about manipulating the most important figure in finance. They joked, or offered small favours. “Coffees will be coming your way,” promised one trader in exchange for a fiddled number. “Dude. I owe you big time!… I’m opening a bottle of Bollinger,” wrote another. One trader posted diary notes to himself so that he wouldn’t forget to fiddle the numbers the next week. “Ask for High 6M Fix,” he entered in his calendar, as he might have putBuy milk”.




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What may still seem to many to be a parochial affair involving Barclays, a 300-year-old British bank, rigging an obscure number, is beginning to assume global significance. The number that the traders were toying with determines the prices that people and corporations around the world pay for loans or receive for their savings. It is used as a benchmark to set payments on about $800 trillion-worth of financial instruments, ranging from complex interest-rate derivatives to simple mortgages. The number determines the global flow of billions of dollars each year. Yet it turns out to have been flawed.

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Over the past week damning evidence has emerged, in documents detailing a settlement between Barclays and regulators in America and Britain, that employees at the bank and at several other unnamed banks tried to rig the number time and again over a period of at least five years. And worse is likely to emerge. Investigations by regulators in several countries, including Canada, America, Japan, the EU, Switzerland and Britain, are looking into allegations that LIBOR and similar rates were rigged by large numbers of banks. Corporations and lawyers, too, are examining whether they can sue Barclays or other banks for harm they have suffered. That could cost the banking industry tens of billions of dollars. “This is the banking industry’s tobacco moment,” says the chief executive of a multinational bank, referring to the lawsuits and settlements that cost America’s tobacco industry more than $200 billion in 1998. “It’s that big,” he says.






As many as 20 big banks have been named in various investigations or lawsuits alleging that LIBOR was rigged. The scandal also corrodes further what little remains of public trust in banks and those who run them.




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Like many of the City’s ways, LIBOR is something of an anachronism, a throwback to a time when many bankers within the Square Mile knew one another and when trust was more important than contract. For LIBOR, a borrowing rate is set daily by a panel of banks for ten currencies and for 15 maturities. The most important of these, three-month dollar LIBOR, is supposed to indicate what a bank would pay to borrow dollars for three months from other banks at 11am on the day it is set. The dollar rate is fixed each day by taking estimates from a panel, currently comprising 18 banks, of what they think they would have to pay to borrow if they needed money. The top four and bottom four estimates are then discarded, and LIBOR is the average of those left. The submissions of all the participants are published, along with each day’s LIBOR fix.






In theory, LIBOR is supposed to be a pretty honest number because it is assumed, for a start, that banks play by the rules and give truthful estimates. The market is also sufficiently small that most banks are presumed to know what the others are doing. In reality, the system is rotten. First, it is based on banks’ estimates, rather than the actual prices at which banks have lent to or borrowed from one another. “There is no reporting of transactions, no one really knows what’s going on in the market,” says a former senior trader closely involved in setting LIBOR at a large bank. “You have this vast overhang of financial instruments that hang their own fixes off a rate that doesn’t actually exist.”



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A second problem is that those involved in setting the rates have often had every incentive to lie, since their banks stood to profit or lose money depending on the level at which LIBOR was set each day. Worse still, transparency in the mechanism of setting rates may well have exacerbated the tendency to lie, rather than suppressed it. Banks that were weak would not have wanted to signal that fact widely in markets by submitting honest estimates of the high price they would have to pay to borrow, if they could borrow at all.



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In the case of Barclays, two very different sorts of rate fiddling have emerged. The first sort, and the one that has raised the most ire, involved groups of derivatives traders at Barclays and several other unnamed banks trying to influence the final LIBOR fixing to increase profits (or reduce losses) on their derivative exposures. The sums involved might have been huge. Barclays was a leading trader of these sorts of derivatives, and even relatively small moves in the final value of LIBOR could have resulted in daily profits or losses worth millions of dollars.



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In 2007, for instance, the loss (or gain) that Barclays stood to make from normal moves in interest rates over any given day was £20m ($40m at the time). In settlements with the Financial Services Authority (FSA) in Britain and America’s Department of Justice, Barclays accepted that its traders had manipulated rates on hundreds of occasions. Risibly, Bob Diamond, its chief executive, who resigned on July 3rd as a result of the scandal, retorted in a memo to staff that “on the majority of days, no requests were made at all” to manipulate the rate. This was rather like an adulterer saying that he was faithful on most days.



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Barclays has tried its best to present these incidents as the actions of a few rogue traders. Yet the brazenness with which employees on various Barclays trading floors colluded, both with one another and with traders from other banks, suggests that this sort of behaviour was, if not widespread, at least widely tolerated. Traders happily put in writing requests that were either illegal or, at the very least, morally questionable. In one instance a trader would regularly shout out to colleagues that he was trying to manipulate the rate to a particular level, to check whether they had any conflicting requests.





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The FSA has identified price-rigging dating back to 2005, yet some current and former traders say that problems go back much further than that. Fifteen years ago the word was that LIBOR was being rigged,” says one industry veteran closely involved in the LIBOR process. “It was one of those well kept secrets, but the regulator was asleep, the Bank of England didn’t care and…[the banks participating were] happy with the reference prices.” Says another: “Going back to the late 1980s, when I was a trader, you saw some pretty odd fixings. With traders, if you don’t actually nail it down, they’ll steal it.”



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Galling as the revelations are of traders trying to manipulate rates for personal gain, the actual harm done would probably have paled in comparison with the subsequent misconduct of the banks. Traders acting at one bank, or even with the clubby co-operation of counterparts at rival banks, would have been able to move the final LIBOR rate by only one or two hundredths of a percentage point (or one to two basis points). For the decade or so before the financial crisis in 2007, LIBOR traded in a relatively tight band with alternative market measures of funding costs. Moreover, this was a period in which banks and the global economy were awash with money, and borrowing costs for banks and companies were low.



“Clean in principle”


Yet a second sort of LIBOR-rigging has also emerged in the Barclays settlement. Barclays and, apparently, many other banks submitted dishonestly low estimates of bank borrowing costs over at least two years, including during the depths of the financial crisis. In terms of the scale of manipulation, this appears to have been far more egregiousat least in terms of the numbers. Almost all the banks in the LIBOR panels were submitting rates that may have been 30-40 basis points too low on average. That could create the biggest liabilities for the banks involved (although there is also a twist in this part of the story involving the regulators).



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As the financial crisis began in the middle of 2007, credit markets for banks started to freeze up. Banks began to suffer losses on their holdings of toxic securities relating to American subprime mortgages. With unexploded bombs littering the banking system, banks were reluctant to lend to one another, leading to shortages of funding system-wide. This only intensified in late 2007 when Northern Rock, a British mortgage lender, experienced a bank run that started in the money markets.


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It soon had to be taken over by the state. In these febrile market conditions, with almost no interbank lending taking place, there were little real data to use as a basis when submitting LIBOR. Barclays maintains that it tried to post honest assessments in its LIBOR submissions, but found that it was constantly above the submissions of rival banks, including some that were unmistakably weaker.



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At the time, questions were asked about the financial health of Barclays because its LIBOR submissions were higher. Back then, Barclays insiders said they were posting numbers that were honest while others were fiddling theirs, citing examples of banks that were trying to get funding in money markets at rates that were 30 basis points higher than those they were submitting for LIBOR.
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This version of events has turned out to be only partly true. In its settlement with regulators, Barclays owned up to massaging down its own LIBOR submissions so that they were more or less in line with those of their rivals.


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It instructed its money-markets team to submit numbers that were high enough to be in the top four, and thus discarded from the calculation, but not so high as to draw attention to the bank (see chart 1). “I would sort of express us maybe as not clean, but clean in principle,” one Barclays manager apparently said in a call to the FSA at the time.



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Confounding the issue is the question of whether Barclays had, or thought it had, the tacit support of both its regulator and the Bank of England (BoE). In notes taken by Mr Diamond, then the head of the investment-banking division of Barclays, of a call with Paul Tucker, then a senior official at the BoE, Mr Diamond recorded what was interpreted by some in the bank as a nudge and a wink from the central bank to fudge the numbers. The next day the Barclays submissions to LIBOR were lower. This could be a crucial part of the bank’s defence..
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The allegation by Barclays that some banks seemed to be fiddling their data would appear to be supported by the data themselves. Over the period of the financial crisis, the estimates of its borrowing costs submitted by Barclays were generally among the top four in the LIBOR panel (see chart 2).



.Those consistently among the lowest four were some of the soundest banks in the world, with rock solid balance-sheets, such as JPMorgan Chase and HSBC. However, among banks regularly submitting much lower borrowing costs than Barclays were banks that subsequently lost the confidence of markets and had to be bailed out. In Britain these included Royal Bank of Scotland (RBS) and HBOS.



The tobacco moment


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Regulators around the world have woken up, however belatedly, to the possibility that these vital markets may have been rigged by a large number of banks. The list of institutions that have said they are either co-operating with investigations or being questioned includes many of the world’s biggest banks. Among those that have disclosed their involvement are Citigroup, Deutsche Bank, HSBC, JPMorgan Chase, RBS and UBS.



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Court documents filed by Canada’s Competition Bureau have also aired allegations by traders at one unnamed bank, which has applied for immunity, that it had tried to influence some LIBOR rates in co-operation with some employees of Citigroup, Deutsche Bank, HSBC, ICAP, JPMorgan Chase and RBS. It is not clear whether employees of these banks actually co-operated or, if they did, whether they succeeded in manipulating rates.



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Continental Europe is focusing on cartel effects rather than digging into the internal culture of banks. Separate investigations, by the European Commission and the Swiss authorities, focus on the possible effects of inter-bank rate manipulation on end users.


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Last October European Commission officials raided the offices of banks and other companies involved in trading derivatives based on EURIBOR (the euro inter-bank offered rate). The Swiss competition commission launched an investigation in February, prompted by an “application for leniency” by UBS, into possible adverse effects on Swiss clients and companies of alleged manipulation of LIBOR and TIBOR (the Tokyo inter-bank offered rate) by the two Swiss and ten other international banks and “other financial intermediaries”.



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The regulatory machinery will grind slowly. Investigators are unlikely to produce new evidence against other banks for a few months yet. Slower still will be the progress of civil claims. Actions representing a huge variety of plaintiffs have been launched. Among the claimants are investors in savings rates or bonds linked to LIBOR, those buying derivatives priced off it, and those who dealt directly with banks involved in setting LIBOR.




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Deciding a figure for the potential liability facing banks is tough, partly because the cases will be testing new areas of the law such as whether, for instance, an Australian firm that took out an interest-rate swap with a local bank should be able to sue a British or American bank involved in setting LIBOR, even if the firm had no direct dealings with the bank. The extent of the banks’ liability may well depend on whether regulators press them to pay compensation or, conversely, offer banks some protection because of worries that the sums involved may be so large as to need yet more bail-outs, according to one senior London lawyer.



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A particular worry for banks is that they face an asymmetric risk because they stand in the middle of many transactions. For each of their clients who may have lost out if LIBOR was manipulated, another will probably have gained. Yet banks will be sued only by those who have lost, and will be unable to claim back the unjust gains made by some of their other customers. Lawyers acting for corporations or other banks say their clients are also considering whether they can walk away from contracts with banks such as long-term derivatives priced off LIBOR.



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The revelations also raise difficult questions for regulators. Mr Tucker’s involvement in the Barclays affair may harm his prospects of being appointed governor of the Bank of England, although he may well have a benign explanation for his comments (he is due to appear before parliament soon).



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Another issue is the conflict central banks face, in times of systemic banking crises, between maintaining financial stability and allowing markets to operate transparently. Whether the BoE instructed Barclays to lower its submissions or not, regulators had a pretty clear motive for wanting lower LIBOR: British banks, in effect, were being shut out of the markets. The two hardest-hit banks, RBS and HBOS, were both far too big to fail, and higher LIBOR rates would have made the regulators’ job of supporting them more difficult.




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This highlights a deeper question: what is the right level of involvement in influencing or regulating market interest rates, in a crisis, by those responsible for financial stability? Central banks get a slew of sensitive information from banks which they rightly do not want to make public. Data on deposit outflows at banks could trigger unnecessary runs, for example. Yet LIBOR is a measure of market rates, not those picked by policymakers.



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Reform club



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Two big changes are needed. The first is to base the rate on actual lending data where possible. Some markets are thinly traded, though, and so some hypothetical or expected rates may need to be used to create a complete set of benchmarks. So a second big change is needed.
Because banks have an incentive to influence LIBOR, a new system needs to explicitly promote truth-telling and reduce the possibilities for co-ordination of quotes.




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Ideas for how to do this are starting to appear. Rosa Abrantes-Metz of NYU’s Stern School of Business was one of a group of academics who, in 2009, raised the alarm that something fishy was going on with LIBOR. One simple change, she proposes, would be significantly to raise the number of banks in the panel. The theoretical changes needed to repair LIBOR are not difficult, but there are practical challenges to reform. The thousands of contracts that use it as a point of reference may need to be changed. Moreover, the real obstacle to change is not a lack of good ideas, but a lack of will by the banks involved to overturn a system that has served most of them rather well. With lawsuits and prosecutions gathering pace, those involved in setting the key rate in finance need to get moving. Adding a calendar note to “Fix LIBORjust won’t do.


OPINION

July 4, 2012, 5:40 p.m. ET

John B. Taylor: Monetary Policy and the Next Crisis
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Low interest rates and international capital flows, not a 'saving glut,' were to blame for the 2008 crash.

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By JOHN B. TAYLOR

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      Corbis



At its annual meeting of the world's central bankers in Switzerland last week, the Bank for International Settlements—the central bank of central bankswarned about the harmful "side effects" of current monetary policies "in the major advanced economies" where "policy rates remain very low and central bank balance sheets continue to expand." These policies "have been fueling credit and asset price booms in some emerging economies," the BIS reported, noting the "significant negative repercussions" unwinding these booms will have on advanced economies.



The BIS emphasizes the view that international capital flows stirred up by monetary policy were a primary factor leading to the preceding crisis and that these flows would lead to the next one. This is in stark contrast to the "global saving glut" hypothesis—which says that the funds pouring into the U.S. in the previous decade originated largely from the surplus of exports over imports in emerging market economies.



The BIS should be taken seriously. It warned long in advance about the monetary excesses that led to the financial crisis of 2008.

 
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The capital-flow story starts during extended periods of low interest rates, as in the U.S. Federal Reserve's low rates from 2003 to 2005 and its current near-zero interest rate policy, which began in 2008 and is expected to last to 2014. These low interest rates cause investors to search elsewhere for yield, and they buy foreign securitiescorporate as well as sovereign—for that reason. Global bond funds in the U.S. thus shift their portfolios to these higher-yielding foreign securities and investors move to funds that specialize in such securities.



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Low U.S. interest rates also encourage foreign firms to borrow in dollars rather than in local currency. U.S. branch offices of foreign banks play a key part in this process: As of 2009, U.S. branches of over 150 foreign banks had raised $645 billion to make loans in their home countries, making special use of U.S. money-market funds, where about one half of these funds' assets are liabilities of foreign banks.




This increased flow of funds abroad—whether through direct securities purchases or through bank lending—puts upward pressure on the exchange rate in these countries, as the foreign firms sell their borrowed dollars and buy local currency to expand their operations and pay workers. That's when foreign central banks enter the story. Concerned about the negative impact of the appreciating currency on their country's exports or with the risky dollar borrowing of their firms, they respond in several ways.



First, they impose restrictions on their firms' overseas borrowing or on foreigners investing in their country. But the differences in yield provide strong incentives for market participants to circumvent the restrictions.



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Second, central banks buy dollar assets, including mortgage-backed securities and U.S. Treasurys, to keep the value of their local currency from rising too much as against the dollar. One consequence of these purchases is a foreign government-induced bubble in U.S. securities markets, as we saw in mortgage markets leading up to the recent crisis, and as we may now be seeing in U.S. Treasurys.



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The flow of loans from the U.S. to foreign borrowers is effectively matched by a flow of funds by central banks back into the U.S. There is no change in the current account, and no role for the so-called savings glut.




Third, in order to discourage the inflow of funds seeking higher yields—which would drive up the exchange rate of their own currencyforeign central banks hold their interest rates lower than would be appropriate for domestic economic stability. There is much statistical evidence for this policy response, and, when you roam the halls of the BIS and talk to central bankers, as I did last week, you get even more convincing anecdotal evidence.


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Call it the lemming effect: Central banks tend to follow each other's interest rates down.




This is what happened in the lead up to the 2008 financial crisis, and it has helped fuel Europe's current debt crisis. In the 2003-2005 period, low interest rates led to a flow of funds into U.S. mortgage markets as foreign central banks bought dollars, aggravating the housing boom and the subsequent bust.



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Moreover, the European Central Bank's interest rate moves during 2003-2005 were influenced by the Fed's low rates. By my estimates, the interest rate set by the ECB was as much as two percentage points too low, which also had the effect of spurring housing booms in Greece, Ireland and Spain. Ironically, the European debt crisis, which originated in the booms and busts in Greece, Ireland and Spain, now has come around to threaten the U.S. economy.



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The Fed's current near-zero interest rate policy, designed to stimulate the U.S. economy, has made it harder for other central banks to combat credit and asset price booms. A group of 18 emerging market central banks—including Brazil, China, India, Mexico and Turkeyheld their interest rates on average as much as five percentage points below widely used policy benchmarks—and global commodity prices doubled from 2009 to 2011, a boom rivaling the excesses leading up to the 2008 financial crisis. This global, loose monetary policy was likely a big factor pushing up commodity prices. The current sharp slowdown in most emerging markets coincides with an inevitable bust of this easy-money induced boom, and the decline of foreign demand for American goods is now feeding back to the U.S. economy.



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The Fed needs to pay closer attention to global capital flows and the reactions of other central banks to its decision to set interest rates very low for long periods of time. This does not mean taking one's eye off the U.S. economy, but rather preventing booms and busts abroad from slowing growth at home precisely when we need it most.




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Mr. Taylor, a professor of economics at Stanford University and a senior fellow at the Hoover Institution, is the author of "First Principles: Five Keys to Restoring America's Prosperity (Norton, 2012).


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Copyright 2012 Dow Jones & Company, Inc. All Rights Reserved

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The bond market

To strive, to seek, to find, and not to yield
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The remarkable demand for low-yielding government bonds
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Jun 30th 2012
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AMERICA can now borrow from the bond markets at a cheaper rate than at any time in the history of the republic. Germany has raised two-year money for a fraction of a percentage point. Even Britain, a weaker economy than either of those two, is enjoying yields on its ten-year bonds that are at an all-time low.




.The deteriorating state of government finances and their rising debt-to-GDP ratios mean there are lots of these bonds to buy. Nevertheless, thanks to the global economic slowdown and the European debt crisis, the demand from savers for safe assets has overwhelmed the supply. Investors have poured $190 billion into global bond funds this year, according to EPFR Global, a data company, while other funds have seen a net outflow of $1.34 trillion. Almost $1 trillion has gone into bond funds since the start of 2009.
Even negative interest rates do not deter investors. The yield on short-term Treasury bills has occasionally been negative in recent years without affecting demand. Safety is all: this is one of those times when, as they say, it is the return of capital not the return on capital that matters.


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But it is more than just one of those times. There have been crises before, but not even the Great Depression pushed bond yields down this far or this widely. The records being set in the markets are due to a combination of peculiar circumstances, cyclical swings and historical shifts. Together they have produced a bond market which is behaving in a way never seen before.



QE or not QE?

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Look at the factors specific to this particular crisis first. A lot of nervous money is leaving crisis-stricken European nations; €100 billion ($130 billion) left Spain in the first quarter of this year. Investors in these countries are worried about the safety of their local banks, the potential for default on government debt and the risk that the country will leave the euro. To a Greek worried that his savings will lose 40% of their value if they end up in drachmas, a near-zero yield on German government bonds still looks like a good deal.



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Panicky demand is only part of the story. Low bond yields are a deliberate aim of central-bank policies to stimulate the economy at a time when they have already cut interest rates to close to zero.



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In America and Britain, the Federal Reserve and the Bank of England have embraced quantitative easing (QE)—the buying of government bonds with newly created money. The Fed has followed this up with “Operation Twist”, a policy that switches its holdings of short-term debt for long-term debt, with the aim of forcing down yields on the latter.
The Fed has also indicated that it is likely to hold short rates close to zero until late 2014; since bond yields reflect expectations of future short rates, among other things, that promise is likely to have lowered them further.
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The impact of all this central-bank intervention is not clear. The Bank of England estimated that its first round of QE lowered government bond yields by a percentage point. But Treasury bond yields rose during the Fed’s two QE programmes; the declines in yields came in between the two programmes, and between the end of the second programme and the start of Operation Twist (see chart 1).



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The odd behaviour of Treasury yields does not in itself prove that QE was ineffective. It may be, as Jim Reid of Deutsche Bank suggests, that investors believed QE would be good for the economy and therefore switched their money into equities and commodities; both markets rallied sharply during the bond-buying programmes. But it does mean that QE is not the whole story when it comes to low yields—a conclusion reinforced by the low level of German yields in the absence of any central-bank bond-buying.




.Low yields are to be expected in any downturn. When the economic outlook turns grim, government bond prices tend to rise, and thus their yields fall. The reasons are twofold. First, during a recession, inflation, the great enemy of bond investors, mostly stops being a worry. Second, a weak economy leads to more corporate failures and falling profits, prompting investors to flee the equity market.




.In such circumstances, investors’ desire for safety tends to overwhelm concerns about the long-term health of government finances. The Treasury bond is the most liquid asset in the world; investors know that they can instantly sell their holdings without moving the price. This tends to make Treasury bonds the beneficiary of any bad news—even bad news about American government finances. When Standard & Poor’s cut America’s credit rating from AAA in August 2011, Treasury yields dropped.


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The effects of the downturn would not count for so much, though, had it not been for the long-running bull market in bonds that preceded it, a market that brought great returns as it drove yields down.



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Martin Barnes of BCA Research calculates that, since September 1981, the real returns for holders of 30-year Treasury bonds have been an annualised 8.8%. That makes the past few decades one of the two great bond bull markets in history; the other was between mid-1920 and the end of 1940, when annualised returns were 9.2%. In both cases, equities rallied as well, for a time. The 1920s and 1990s are better known as equity bull markets than for their bond returns. But equities eventually faltered (in 1929 and 2000), whereas bond yields drove remorselessly lower (see chart 2).
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But now that bond yields have fallen so far, the road ahead looks barely trafficable. The capital gains that bond investors make as yields fall (and prices rise) are one of the two ways in which they make a return; the other is income from interest. When yields approach zero potential returns peter out; the income is reduced and the scope for further capital gains is limited.



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The thunder and the sunshine



History suggests that investing at the current low level of Treasury yields is a very bad option. Investors who bought Treasury bonds at a 2% yield in 1945 earned a negative real annual return of 2.3% over the following 35 years, according to the Barclays Capital Equity-Gilt study.




There is, though, a prominent counter-example: Japan. Ten-year Japanese bond yields fell below 2% in the late 1990s and have stayed below that level for most of the time since. Hedge funds which bet that Japan’s deteriorating debt-to-GDP ratio would eventually cause its bond yields to soar as the price of bonds dropped have been repeatedly disappointed.



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Generalising from Japan’s experience would be risky. Its debt is owed mostly to its own citizens rather than to foreigners, so it has been saved from the kind of confidence run that has bedevilled Greece and Spain. And Japanese prices have been flat or falling for most of the period, so real bond yields have still been positive.




.In America, Britain and Germany ten-year bond yields under 2% are now lower than the explicit (or implicit) inflation targets of their central banks. Investors are expecting to lose money in real terms. The same phenomenon can be observed in the index-linked government-bond market, where both interest payments and the maturity value are pegged to inflation. Many index-linked bonds in America and Britain are trading on a negative real yield.




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Real yields have been negative before. In the 1970s, investors were caught out by a sudden surge in global inflation, and were too slow to push yields higher in response. But push they eventually did, and by the 1980s yields were high, real rates positive and the scene set for the subsequent bull market. The legend grew of the “bond market vigilantes” who would intimidate governments that pursued loose policies.




.The low real yields of the 1970s were part of a longer period of poor bond returns which can in part be explained by what is known as “financial repression”. Carmen Reinhart of the Peterson Institute for International Economics and Belen Sbrancia of the University of Maryland calculate that average real rates on deposits and Treasury bills were negative throughout the 1945-80 period in advanced economies. They explain this in terms of the policies governments used to escape from the debt burden of the second world war.



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Governments were helped in keeping rates down because of the capital controls they ran as part of the Bretton Woods system of fixed exchange rates. Those kept savings corralled in their domestic market. But there was also regulation that meant pension funds, insurance companies and banks bought government bonds regardless of the yields on offer.




.A similar effect may be occurring today. In response to the crisis of 2008, commercial banks are now required to hold liquidity cushions, usually in the form of government bonds. Regulations are also forcing bonds on insurance companies. In addition, central banks have been lending at low rates to provide liquidity. Banks that have benefited from the European Central Bank’s Long-Term Refinancing Operations have invested some of the money in government bonds. Pension funds once pushed into bonds by regulation are now kept there by demography: retiring members need to be paid their income.



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Help, help, I’m being repressed


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In addition to these domestic enthusiasts, Western governments have also been able to tap overseas savings. Central banks hold government bonds as part of their reserves, with Treasury bonds being by far the most popular asset. Foreigners own 43% of all Treasury debt; official institutions, largely in Asia and in oil-exporting countries, own around $3.5 trillion-worth. These central banks are either just looking for a liquid home for their assets or buying the bonds as a way of managing their country’s exchange rate against the dollar.




.Add together the purchases of global central banks, domestic central banks (via QE) and financially repressed institutions, and well over half of British and American government bonds may be owned by investors who are relatively unconcerned about low yields. Mutual-fund and hedge-fund managers, more bothered about making a decent return, are thus hard put to play the role of vigilantes, so the state of the market is no longer the economic signal that once it was.



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Indeed, in historic terms, conventional wisdom about bond markets has been turned on its head. The gold standard and the Bretton Woods system were both ways of reassuring international creditors that their holdings would not be eroded by inflation or currency devaluations; countries with a sound currency were rewarded with lower borrowing costs. But one reason why British yields are so low today is that investors believe the country has the flexibility to depreciate its currencyunlike the southern European countries which have to choose between austerity and default.



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This division of bond markets into a premier league (of governments that can borrow at less than 2%) and the minor leagues (of those paying 6% or more) is a great advantage to those countries in the former category. America and Britain, in particular, can finance very high deficits (by historic standards) without feeling under pressure. Indeed, despite many years of current-account deficits, both countries have a surplus on their investment-income accounts, largely because foreigners earn such low yields on their dollar and sterling deposits and bonds.



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It is a neat trick: buy real goods and services from other countries and sell them low-yielding pieces of paper in return. And it looks like one that may have a fair bit of mileage left. Investors starved for choice may not relish yield-free bonds. But they seem likely to keep buying them.