What makes this article a bit confusing is that they give an answer without making it clear what the question was.
Here's the missing question: Imagine you are a Eurozone pension fund or life insurer. You have to invest billions of euros very safely and eek out a return that is no less than inflation. How do you do that?
Inflation (HICP) was 1.73% in 2018. German Bunds, the safest euro denominated investment with sufficient volume, yield close to 0%. Now you look across the Atlantic and find that 10 year treasuries yield 2.63%.
The problem is that simply investing in treasuries wouldn't work because currency fluctuations would likely dominate any interest income. So you would need to hedge the currency.
The Bloomberg article is about why hedging the EUR/USD currency pair is currently too expensive for this idea to work.
It matters for European savers, including everyone who is paying into a defined contributions pension (e.g most workplace pensions). A significant chunk of those savings currently yields negative returns. The alternative is to take a lot more risk than you want to or are allowed to take.
Absolutely, but if an institution is taking some form of deposit in euros and promises to make predictable payments in euros then being long euros is not a directional bet for that institution.
Of course the picture gets a little murkier once you start considering inflation caused by exchange rate fluctuations. But that is probably not the main concern in a large currency area with an independent central bank.
We must have different ideas of what fx fluctuations are, +/-500 bps over a decade sure… not +/-500bps on -30% decline line over a decade vs a major pair…
Yeah it has to be the assumption, but at the same time it makes one wonder why EUR/USD hedging is increasingly expensive in the first place… though if one pulled up a monthly chart going back 10 years and their head wasn't tucked between their legs, its easy to see why.
>What DC scheme wouldn't let you put say 100% in shares?
I'm looking at it from the point of view of fund managers. If the fund promises to invest 50% in bonds then someone's job will be to find suitable bonds.
If you're young and you are free to choose how you want to save for your pension then I agree that stocks are probably safer. Perhaps even if the whole world slowly turns into Japan.
Because the ECB had negative rates for a while, i.e. some parties had to pay to hold cash.
And lastly, because economic developments which don't affect cash, may affect bonds. i.e. if the interest rates drop, existing bonds will become more valuable. I don't expect this to happen, but the point is that you don't just buy bonds for their return today, but also in expectation for their relative return compared to the rest of the bond market in the future, i.e. their future value. That doesn't apply to cash in the same way.
Where do you hold the cash? Physically? As deposits in a bank? “Cash” is short hand. This article debates different forms of cash. (OTR sovereign bonds are usually considered cash.)
It's deposits in a bank, yes.
Many banks charge large deposit holders a negative interest rate.
The alternative of holding it in actual cash, comes with security costs, storage costs,...
The negative interest rate is still cheaper then the 1% annual cost of securing banknotes.
It also puts an implicit floor on how low the central bank can lower the interest.
> Many banks charge large deposit holders a negative interest rate
Counterparty risk dominates, for most treasurers. You don’t want your billions of corporate deposits in the bank that went bust. Treasuries—or their local equivalent—are a safe way to hold cash.
In the world of finance, "cash" is often shorthand for "cash or cash equivalents".
Instead of the usual layperson interpretation where cash is "a bunch of currency, either physically in my hand or in a bank account", the meaning here is "stuff with incredibly low risk" i.e. you can be very sure that you'll not lose money over time.
Sovereign debt, including bonds, is regarded as the safest type of debt and therefore falls into the 'risk-free' bucket in the finance world. Since cash is usually regarded as risk-free, the word "cash" has come to be a short-hand for "(almost entirely) risk-free assets".
Yeah, but using the word "cash" that way isn't a good idea. I understand why they do it but it's still asking for trouble.
For one, sovereign bonds are very obviously not risk free. Governments have a long history of going bankrupt or giving bond holders haircuts. They're treated as such because regulations passed by governments force them to be treated as such, which is clearly self-serving. The finance world is mixing up "we must pretend it's risk free" with "actually risk free".
"Cash" is also not risk free. Probably higher risk than US, Japanese, German, or British bonds. In the current fiat era a country is more likely to print money than default on its bonds. Countries that have recently gone bankrupt or gave bond holder haircut, rarely can borrow in their own currency anywhere near the rates on US dollar denominated loans.
Printing money to pay a debt is defaulting in any sense that would be understood by a layman. The loan has technically been paid, but in a way that voided the point of requesting payment (transfer of value).
Again, the fact that it's not considered that way says more about the finance industry than it does about ordinary terms like cash.
Credibility claimer: I built risk systems for 3 Tier-1 investment banks in a previous life.
I'm not a fixed-income (read: bonds and other interest-rate derived financial instruments) person, but I think the erosion of 'value' via inflation is missing the point.
Sovereign debt is the least risky form of debt there is, period. Everything else that's denominated in the same currency has more risk, not least due to the fact that the pricing of every financial instrument takes the risk of the sovereign debt into account aka the risk-free-rate.
Yes, the absolute amount of risk of a sovereign debt is different depending on who controls a particular fiat currency - but in relative terms, any financial model will start with that baseline. Obviously, cash in that same currency bears some risk due to inflation, which is why people talk about 'real interest rates' that take that into account.
If you lend someone money, you take risk, and you get interest as compensation. That risk includes your predictions of inflation, and the interest rate you are prepared to accept should include that too. If you don't like it, don't lend the money.
Arguing about a 'transfer of value' implies that you have another way of representing value that is better than the currency itself. I can't think of one, but I'm open to suggestions.
Currency is a fine way to represent value, but a currency that's being inflated is certainly a worse way than a currency that isn't. If a government plans to inflate its way out of debt, the markets respond to that by trying to charge higher interest, but ultimately governments (outside the eurozone) control their own currencies and their own inflation statistics, so the markets are always playing catchup.
A truly risk free currency would be a currency that couldn't be inflated by a government to escape from its debts, like a cryptocurrency (if they actually worked).
For most of history there was gold and/or silver. Fiat currencies have always been short lived. Our current fiat phase started in the 1970's so maybe it can survive a little longer?
And this is a big part of the reason the majority of pension systems in Europe are going to be bankrupt within 10 to 15 years. (The other part being the inverted population pyramid)
There aren't that many defined benefits workplace pension schemes left. Some have already gone bankrupt. Others were restructured into defined contribution schemes.
And state pension schemes are not usually investment based at all. They are usually funded by current social security contributions and taxes. If they go bankrupt it's for political reasons.
More likely than bankruptcy is that many people will receive lower pensions than they had hoped for.
Here's the missing question: Imagine you are a Eurozone pension fund or life insurer. You have to invest billions of euros very safely and eek out a return that is no less than inflation. How do you do that?
Inflation (HICP) was 1.73% in 2018. German Bunds, the safest euro denominated investment with sufficient volume, yield close to 0%. Now you look across the Atlantic and find that 10 year treasuries yield 2.63%.
The problem is that simply investing in treasuries wouldn't work because currency fluctuations would likely dominate any interest income. So you would need to hedge the currency.
The Bloomberg article is about why hedging the EUR/USD currency pair is currently too expensive for this idea to work.
It matters for European savers, including everyone who is paying into a defined contributions pension (e.g most workplace pensions). A significant chunk of those savings currently yields negative returns. The alternative is to take a lot more risk than you want to or are allowed to take.