In a December report, the Organization for Economic Co-operation and Development noted that its member governments “are facing unprecedented
challenges in the markets for government securities as a result of continued strong borrowing amid a highly uncertain environment with growing concerns about the pace of recovery, surging borrowing costs, sovereign risk and contagion pressures.” The report projects that industrialized governments’ gross borrowing needs will exceed $10 trillion next year, and government deficits are estimated to be 6.6% of the income bases of those countries. Private saving is not likely to cover the growth of debt. This leaves a funding scarcity for plant and equipment as well as sustained economic growth — meaning you can finance governments or economic growth, but not both.
While those are the raw numbers of both rollover and additional bonds to be absorbed, the report fails to point out all the incentives for private parties to divest themselves of the same securities. The incentives to get out of the bond pool include: bank deleveraging (which results in the selling of government securities); the pending rating downgrades of Euro sovereigns and the questionable value of financial insurance on the Euro sovereign bonds due to counterpart risk.
If, these are not ample reasons for investor concern; there is more. The list should also include the risk of a devaluating Euro if capital flight occurs; or if a country were to pull out of the Euro zone, euro claims would then be denominated in some new home country currency that is bound to fall in value. If that is not enough to cause one to pause before investing in the $10 trillion to be offered this year, there is a possibility of a preemptive Euro zone sovereign default, and countries do not hand over their hard assets to a bankruptcy trustee to be distributed to bond holders as with a private bankruptcy.
Aside from these incentives to NOT be swimming in the government securities pool, China’s declining trade balance surplus will reduce its accumulation of developed-world government bonds. So the doctrine of “spend now and send to the bill to China” is grinding to a halt just when it is really needed.
Euro governments were expected to address this shakiness in government bonds at the recent summit by agreeing to put themselves on a debt budget. However, when push came to shove, the summit revealed that the combined governments of the EU were unable to strengthen the fiscal responsibility provisions of the Maastricht Treaty. They settled on each individual country legislating debt controls. Since we have already seen the U.K. say, “Yes, BUT …” to fiscal responsibility, the precedent has been set for each country in turn to say, “Yes, BUT …” to protect their own sacred cows. So much for solidarity.
The summit also revealed that even in a crisis Germany would not spread its own fiscal largess to the common protection of other governments’ debt. Germany’s demur, while consistent with its genealogy, was no doubt influenced by the shock of a failed auction of German Bunds over Thanksgiving.
So where are we on the greatest fiscal weakness and threatened financial collapse since the Great Depression? There are no fiscal resources, no hidden piggybanks of stored-up reserves for a rainy day. Government rescues of other governments or their banks would need to be debt financed, which is the problem and hardly a solution. Hence, we are left with the one big option of monetization. Think of this as market support based solely on liquidity rather than solvency.
While direct monetization of Euro sovereigns is taking place at the rate of $20 billion per week (more than $1 trillion per year), most of the government bond support under the Euro treaty would need to be accomplished in an indirect way. Since the treaty inhibits the ECB from doing a Quantitative Ease and purchasing a large stated block of government debt, its support of sovereigns is via “unlimited” super-cheap three-year loans to banks, which can use the full face value of the government bonds as collateral. Think of the leverage, the incentives and the profitability for the banks. Purchase an underwater Greek bond in the secondary market, say at half of face and borrow the full face of the bond and profit from the wildly high spreads.
This two to one loan-to-value ratio is a carry trade that even hedge funds can be very envious of. In the first day of this new lending program, the banks borrowed $635 billion. For the ECB as the lender, this was a balance sheet expansion that exceeded the Fed’s nine month QE2. However in the logic of no free lunch, the loan program supports bank solvency and in turn government bond prices which are the most immediate problems, but it shifts the financial system’s insolvency from commercial banks to the central bank and raises the question of will the market flee the Euro when this becomes understood.
While this is material support that can and has gone a long way to relieving Euro bank liquidity problems in the last two weeks, it still does not generate enough comfort for non-bank private wealth to continue funding the government bonds with its own capital rather than ECB easy money loans. Private wealth owners are still left unsure of whether the central bank government bond “put option” (willingness to support the price) will be in place.
To the private investors in Euro sovereign debt, the central banks being the buyer of last resort is not a strong enough commitment. They care more about financial protection of their asset. They want the central bank to establish a floor price, not just to protect their investment but also to insure that the borrowing government’s cost of money does not rise above the threshold of fiscal survivability. This means that central banks more than ever are in the financial price-fixing business to keep the non-bank private investors swimming in the pool of sovereign indebtedness. Setting the minimum price is better known as an interest rate “peg,” which is far better financial insurance than a CDS contract. It is financial insurance that investors do not need to pay for, and the central bank is a better counter party than some unidentified AIG in the making on the other end of a CDS contract.
This reminds one of the Fed’s great interest rate peg of WWII. Scarcely 90 days into the war, the Fed, seeing the slippage in government bond prices due to the market’s anticipation of being flooded with Treasuries to finance the war, stepped in to announce the Accord. This agreement in effect provided investors with a put option to protect the price of Treasuries for the long haul — defined simply as “the duration” (which lasted nine years). This encouraged the private buying of Treasuries in addition to the Fed’s buying.
The same is being asked of the ECB for the same purpose today. The ECB has implied it will do the same, but it can only offer hints, as the Treaty does not condone it. Critics say there is a lack of clarity in the ECB’s put option or price support that hinders Europe’s sovereign funding. This is true: third-party guaranteed debt is better than holding the paper without a guarantee. Moreover, it is in the interest of the ECB to provide financial guarantees as any private funding shortfall of government debt must be covered by the ECB’s own balance sheet.
This raises a key issue: What are the market implications from a central bank interest rate peg? What is being described, for as long as it holds, is an asset bubble centered in the first instance on government debt. It’s not the garden-variety asset bubble of tulip mania or more recently of housing mania that gave rise to behavioral finance ideas of confidence in ever-rising values, but an ongoing departure of sovereigns pricing from some underwriting standards of fundamental value that one can read from an Excel spreadsheet. It’s not irrational exuberance or excessive speculation, but it’s an asset bubble nonetheless. The question is, what other asset prices are affected, and in what direction and for how long?
To the extent that market yields are held lower than what the market would price on its own for a long period of time, and U.S. Treasury yields are indeed at all-time lows, these induced lower yields spill over to a generalized asset pricing bubble for assets associated with income streams. This is because a lower discounting rate of income streams makes the streams more valuable, so the distortion to fundamental value carries over to other asset classes as well. This is a reasonable interpretation of the price buoyancy of dividend-paying common stocks, preferred stock, apartment REITS, farmland, high-quality U.S. debt, pipelines, utilities, etc. And don’t forget the ramping up of the carry trade for similar assets when many central banks are aggressively pursuing expansion whether or not they are specifically targeting ZIRP (zero interest rate policy).
But which income streams will be most affected: fixed income or income streams with some upward inflationary response? If you believe that containing Euro fiscal deficits and deleveraging of finance will produce deflation, then high-quality fixed income is inflated by the bubble. If you think that the central bank’s spending power will ultimately generate inflation, then incomes producing real assets become most favored. With likely bimodal distribution of expectations on inflation/deflation, there are camps that support both.
As long as the government bond dam holds to keep liquidity in the Euro government bond market, those assets classes stand to benefit — but the bigger issue is, how long can the dam hold? When the market wants out of Euro sovereigns, the liquidity that seeps out must be replaced by the central banks. That means the rate of expansion of the central bank’s balance sheet now accelerates to cover both a fraction of the new issuance of government bonds, but also the quantities of government bonds the private market is casting aside.
It is possible that emulating the Fed’s 1940s successful sovereign price support (pegging of interest rates) could give Euro governments years of financing survivability as it did for the U. S. and some hope that growth will kick in — but there are too many ways the dam can be overrun, despite all the bank incentives and government promises. In the meantime, it’s an ultimate test of whether debt prices can be maintained with liquidity alone, irrespective of the solvency of the underlying bonds. That is, can liquidity trump insolvency?