Following the 2007 sub-prime mortgage meltdown and the subsequent contagion that took down virtually every asset class and in turn the institutions that held those assets, the government of many countries were called upon to stabilize financial asset prices, the institutions, and the economy which would otherwise be deprived of business and consumer lending.
The size of the financial system insolvency alone in several cases was comparable to a sizable chunk of the country’s GDP and when adding to it the need for fiscal stimulus many countries were forced to go “all in.” By this I mean that governments were called upon to seek maximum funding from the government’s bond markets to finance the bailouts that followed.
In addition, each country’s monetary authority was called upon to step up to the plate to also participate in stabilizing the erosion of financial prices. In many cases such as with the US’s Federal
Reserve banks, the size of the asset purchases represented a giant leap forward in the size of its balance sheet which rests upon funding from money issuance or claims on money issuance.
In turn over the following months, those who has been schooled in the monetary multiplier and the ability of commercial banks to ramp up lending and presumably spending and given the dictates of monetarism that such monetary base increases inevitably generate inflation were reluctant to hold fixed income securities. In particular the ardor for the US Treasury suffered and the market yields rose quite a bit which is anathema to a central bank’s attempt to manage the economy out of a recession. Furthermore the fear was present that the government fiscal deficits would cause the central bank to monetize future government fiscal deficits as well, a rumor that the Fed gave support to by announcing that a substantial Treasury purchase would follow.
In the wake of these events, inflation expectations not only pushed down especially US Treasury bond prices, but there occurred a capital flight out of the US Dollar. Through most of 2009, the Dollar fell 15% against a market basket of currencies as capital retreated and markets sought assets denominated in other currencies. In particular capital fled to emerging market denominated debt and to commodities.
In order to get a handle on the inflation expectation it had generated, the Fed cleverly announced that it had a secret “exit” plan for the monetary stimulus it had just thrown into the market. While not being specific in terms of timing, the amount or the form of the exit, the Fed cleverly created expectations that it would remove the objectionable monetary stimulus. At this point as we near the spring of 2010, a time period that the Fed announced would be the end of some of its financial asset support programs, the market was waiting with mixed emotions for the promised exit. In fact exit generated the alternative market fear that the end of stimulus would occur when the economy was clearly not advancing in a healthy self-sustained manner.
While this drama was unfolding, the US and the Fed caught a break. Starting in December of 2009, the leakage of market support for US assets suddenly reversed as it seems there were other sovereign distresses situations that were more pressing than those of the US. A group of Euro block countries it seems were considered to be even shakier than the US. The so called, PIGS, (Portugal, Ireland, Greece and Spain) of the Euro block since they did not have their own individual country central bank to support its government debt ran into market resistance to its sovereign debt funding. Suddenly a developed country’s default potential was no longer theoretical and the market came to develop sovereign risk spreads with now hundreds of basis point spread between the financially weak sovereigns relative to the German Bund.
The good short term news for the US however is the world again loved Dollar assets as we were thought to be good by comparison and there was a rapid reversal back into the Dollar and into short term Treasuries whose yields fell to near zero. From our perspective we once again enjoyed lower interest rates without the Fed needing to lift a finger and frighten the market in doing so.
The PIGS incident is significant in that it also lead to the beginning of the “science” of the appraising and pricing of sovereign risk that replaced the science fiction that the developed world does not default. Reference is made to Bill Gross’s, February 2010, “Ring of Fire” obtainable on www.pimco.com that shows sovereigns that are in the circled ring of fire, with the US being one, that have both a high starting government debt to income ratio and prospects for decades of additional debt growth relative to income.
Alas, sovereign default risk is no longer science fiction but a growing reality of life in the developed world that will have strong pricing effects not just on the sovereign debt but private debt in the impacted currency. This presents the analysts and markets with one more major complication to contend with in this post financial crisis world.