A French bunker for European evacuees

As France joins the club of European countries issuing debt at a negative interest rate, investors are flocking to these safe havens, deepening the market rift between northern and southern Europe.

The strength of the deflationary forces now gripping the global economy were starkly illustrated overnight when Paris revealed that it had become the latest country to issue debt at a negative interest rate.

Overnight, Paris benefitted from negative interest rates for the first time when it went to the market to raise almost €6 billion ($US7.4 million) in short-term debt. It issued close to €4 billion in 13-week bills at a yield rate of 0.005 per cent, and just under €2 billion in 24-week bills which paid a negative yield of 0.006 per cent.

Negative interest rates mean that, effectively, investors are prepared to pay to lend money to a country. Investor demand for French debt is now at record levels, and this has pushed bond prices up sharply. Because bond prices and bond yields move in inverse directions, this means that French bond yields are plumbing new lows, and even dipping into negative territory at the very short end.

France has now joined a select club of European countries, including Switzerland, Germany, the Netherlands, Finland, Denmark and Austria that have been able to borrow at negative rates even though last January ratings agency Standard & Poor’s stripped both France and Austria of their coveted triple-A ratings.

Investors are flocking to French bonds in the hope that its economy – unlike its southern neighbours – will be able to avoid a recession. French Prime Minister Jean-Marc Ayrault, has recently tipped that the French economy will grow by around 0.3 per cent this year and around 1.2 per cent next year. And it comes at a time when investors are increasingly worried about the gloomy outlook for the global economy, following the weak US jobs figures on Friday and the recent warning from Chinese premier Wen Jiabao that the Chinese economy is facing "huge downward pressures”.

The drop in France’s short-term interest rates overnight also reflects the fact that investors are now eagerly searching for alternatives to extremely expensive German and Dutch bonds.

Still, these countries again demonstrated their allure for investors overnight, with Germany paying a record negative yield of 0.03 per cent on €3.3 billion in six-months bills, while the Dutch also sold short-term debt at a negative yield.

Indeed, Germany is such a favourite with investors that it is able to issue longer-term debt at negative rates. Two months ago, the German finance ministry issued €4.6 billion of two-year bonds which paid an interest rate of zero per cent. This means that, after allowing for inflation, investors were happy to pay to park their money with the German government.

Many believe that northern European countries are benefitting from the deepening eurozone crisis. As investors become ever more anxious about the outlook for Spain and Italy, they’re prepared to accept even lower rates for the perceived "safe haven” offered by countries such as France and Germany. This has led to an increased rift in the market, with Spanish 10-year bond yields overnight climbing above the critical 7 per cent level, while short-term interest rates in northern Europe dropped to negative levels.

There’s also little doubt that the downward pressure on interest rates for European countries judged to be 'safe' has intensified in the wake of the European Central Bank’s move last week to cut its key lending rate to 0.75 per cent (from 1 per cent previously), and to reduce its deposit rate from 0.25 per cent to zero.

Before this move, European interest rates had been slightly higher than in US and Japan, where central banks had slashed rates close to zero during the financial crisis.

But in the wake of the ECB’s move, a number of large global fund managers have decided to close, or restrict, their European money market funds to new investors. They argued that the ECB’s move to cut the deposit rate to zero would almost certainly push some yields into negative territory as investors rushed to buy up the limited supply of high-quality debt. This would lower the funds’ returns, and dilute returns to existing investors.

They pointed out that before the ECB’s move to cut the deposit rate to zero, some banks had been borrowing money from European money market funds, and depositing the funds with the central bank, which generated some return for the funds.

In addition, they noted that the ECB’s previous decision to flood the European banking system with €1 trillion in cheap money meant that well regarded banks were issuing fewer securities, which meant there were even fewer good quality assets to buy.


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