Sunday, December 13, 2009

NYT: Bond Vigilantes Prowling Europe

It is becoming more clear, at least from this perch, that as the obligations of the private sector have been moved to the public balance sheet over the past 2 years, combined with long term budget paths in many Western countries (and Japan) sovereign debt is going to be the next (and frankly largest) crisis of this generation.  With the countries potentially afflicted in the next 2 decades... among the largest economies in the globe (United Kingdom, United States of Debtors, Japan), it could should make the events we just experienced the past 24 months look like a cake walk.  The US government / Federal Reserve backstopped the US financial system.... but who backstops the US government / Federal Reserve?

The same question must be asked by nation after nation which is headed down the same path - from smaller to larger.  I assume Germany, France, China, Australia, and Canada (or any smaller countries running fiscal surplus or benign deficits) can't bail out all these major economies.  Any number of PIIGS (Portugal, Ireland, Italy, Greek, Spain) should be the world's first tests in the next 1-7 years, after that the timing is questionable due to policy decisions and confidence in a system where the central bank can save us all, when it comes to the days of destiny in the UK, and US.  [Apr 23, 2009: Britain's Deficit Reaches World War 2 Levels; Very Little Room to Maneuver]  Maybe 15 years, maybe 25... or maybe much sooner.  All one must do is think back 12 months to see how confidence in "the system" - when shattered - can lead to panic.  The safety blanket of the government / central bank is all that keps this patchwork of human belief together.  What happens when the belief in central government and bank is quashed?

I don't believe it will be a question of "if", but "when" - which I think is the true reason for the increase in gold.  The issue of sovereign debt is not even in the first out of the top of the first inning, but for the coming generation (20 years) could very well be the most impactful situation facing the globe. For investment purposes it will be very important to have some form of portfolio insurance at all time because the switch from "ignoring the problem" to "fleeing in abject fright from reality" can happen overnight.  We are very quick to forget as humans... and those who only focus on the next few days, or weeks/months will continue to dismiss such concerns.  They are the most likely to be wiped out financialy when said events actually occur.  Ignorance is bliss investing only works for limited periods of time....

Via New York Times:
  • The bond market vigilantes are back.  But this time they are roaming mostly through Europe rather than the United States — at least for now seeking to impose fiscal rectitude on governments politically unable or unwilling to take the painful steps necessary to close gaping budget deficits.
  • You remember the bond vigilantes, don’t you? As big investors in the credit markets, they developed a fearsome reputation in the early 1990s by collectively putting pressure on a newly elected U.S. president, Bill Clinton, to abandon his campaign promise of tax cuts. Instead, Mr. Clinton followed the advice of Robert Rubin, who joined the Clinton administration from his post at the top of Goldman Sachs and who made the case that a policy of budgetary restraint would keep interest rates on U.S. government bonds relatively low.
  • Now, the bond market posse is on the hunt again, turning its attention most acutely on Britain and Greece, where left-leaning governments are struggling to demonstrate that they have a workable plan to reduce deficits that are the highest in Europe — about 13 percent of gross domestic product. (as is the United States... over 12%)
  • In Greece, the spreads between Greek 10-year bonds and their benchmark German counterparts soared to highs of 250 basis points last week as concerns grew over Greece’s ability to service its enormous debt.
  • In Britain, bond investors greeted a prebudget Labour Party report that skimped on details of spending cuts with a sell-off that pushed gilt yields to their highest level since the depths of the financial crisis.
  • In Ireland, by contrast, the government presented the most severe budget in the country’s history, largely to prove to wary bond investors that it was serious about cutting its own deficit. (remember, they have 'dire' proposals, such as 9% wage cuts for all public workers - can you imagine the uproar and strife if this happened in America?  It won't be left to the imagination within 2 decades, on the current path....)
  • “There is a greater market focus now on who the fiscally vulnerable countries are,” said Michael Saunders, the head of European economics at Citigroup. 
  • In particular, Mr. Saunders sees the Labour government in Britain — which is facing an uphill election battle — as being more concerned with pleasing voters than investors, a stance that he says could lead to a bond market rout if gilt holders, a large proportion of them foreign, come to the conclusion that cutting the deficit is not a top priority.  (Britain is most like the US, so the one to watch for Americans - except they don't have the benefit of the default world currency to bail them out and keep the mirage going for an extra 5 to 10 years)
  • For most of the past decade, though, the vigilantes have been in abeyance, since public-sector deficits were not an investor concern.  With the onset of the credit crisis last year, they surfed the global liquidity wave, buying up government debt all over the world in the view that, just as most big banks were too big to fail, so were sovereign economies, no matter how crushing their fiscal picture.
  • But Dubai World’s decision to delay payment on its debt has been a slap in the face of complacent bondholders. The immediate result has been a demand on their part for higher interest rates in the most vulnerable countries, adding to the potential borrowing costs of countries like Britain, Greece, Ireland and Spain that have benefited from lower rates because of the dearth of private borrowers in the global downturn.
  • As a result, governments in Portugal, Ireland, Greece and Spain have had to turn to increasingly dubious bond markets to raise funds while waiting for their economies to recover through the far more painful process of squeezing wages and shedding jobs to restore competitiveness.
  • The United States and Japan also face unusually high debt levels, spurred by huge stimulus programs. For the time being, investors are still willing to lend to them at generous rates. But bondholders are running out of patience with the most vulnerable countries.
  • A report from Standard Chartered said as much last Friday, forecasting bailouts, if not actual ejections, from the euro zone for Greece and Ireland once investors decide to pull the plug and stop refinancing the countries’ debts. (the drama here should be enormous, both in real terms, and in the markets - Dubai was a pimple on the rear end compared to the potential of bailing out or ejecting member Euro nations)
  • The idea that currency unions can’t break up is rubbish,” said Tim Congdon, an economist and admitted Euroskeptic who has advised Conservative governments in Britain. “The critical issue is whether governments can repay their debts in new currencies or euros once they leave.”  If they can pay back bond investors in new and cheaper currencies, then it is in the interests of countries like Greece to go out on their own, Mr. Congdon said.
  • But with other countries seeking the shelter of the euro and leaders like Angela Merkel of Germany hinting that the big powers would come to the rescue of Greece and other distressed countries if necessary, most economists argue that the euro zone is unlikely to crack.
  • Still, that hasn’t stopped bond investors from talking up a new divergence trade in Europe — the flip side to the convergence trade earlier this decade, during which Irish, Greek and Spanish government bonds were bought on the theory that a grand economic harmony would sweep Europe.
  • In Britain, what was once unthinkable is now being discussed: a possible downgrade of the country’s triple-A rating. Moody’s recently affirmed the rating, citing the ease with which the Treasury had been able to raise funds, but some analysts are convinced that a downgrade is inevitable. “There is a clear drop in confidence on the part of bond investors,” said Mark Schofield, a fixed-income strategist at Citigroup in London. “I think it is all beginning to unravel.”

[Dec 10, 2009: Ken Rogoff (Videos) - Sovereign Debt Defaults Likely in Next Few Years]
[Dec 10, 2009: Global News - Ireland takes Responsible Budget Steps, Spain the Next to Worry About]
[Dec 8, 2009: Greek Fiscal Situation Continues Slow Boil]
[Dec 1, 2009: Morgan Stanley Lists UK Sovereign Debt / Currency as Potential "Fat Tail" Risks for 2010]
[Nov 27, 2009: UK Telegraph - Greece Tests the Limits of Sovereign Debt as it Grinds Toward Slump]
[Sep 17, 2009: Ireland to Spend 28% of GDP to Suck up Banking Toxic Assets]

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