Archive for June, 2012

PIGS Might Fly

That, at least, is one prevalent view: whatever summits are convened and decisions made, Portugal, Italy, Greece and Spain will leave the eurozone. There are many who think that this is a great idea. In the long run, so they say, devaluation will improve competitiveness and thereby increase growth and employment.

Of course we know what happens to all of us in the long run. And the short run consequences are not likely to be pleasant – indeed, can be terrifying. In Iceland only four years ago, for example, the currency became unsaleable for a period and panic set in over the availability of (mostly imported) food.

There are reasons not to be quite so enthusiastic about the idea closer to home too. In the economic sense at least, Britain is not an island. There are real concerns about the effect on our own prospects that deeper uncertainty on the Continent would have.

Furthermore, there is no reason to suppose that bond markets – the most likely mechanism for triggering another sovereign bailout – would stop at chasing away the PIGS. When financing for Italy looked in greatest jeopardy last November, bond yields in France came under pressure too: ten year French bonds rose from a spread of 0.3% above their German equivalents to almost 2%. To many at the time this seemed the natural way for the crisis to spread.

The problem is that while Greece is a relatively small economy, France and Italy are giants. In absolute terms, the national debt of Greece is substantial, having risen to over €350bn by the end of last year. But for Italy and France, the numbers are over ten times bigger at more than €3.6trn. Writing down the value of debt on that scale – along the lines that Greece did this year – could really lead to “contagion”. To put the number into context, it is (on Bloomberg tracking) hundreds of billions bigger than the total writedowns suffered and capital injections required as a result of the financial crisis by all financial institutions, worldwide.

Sticking with the numbers for now, many seem not to realise that it would be nigh impossible to bail such large economies out. Between them they have around €420bn of bond and money market debt to refinance by the end of the year – and that doesn’t include the amount required to fund their budget deficits or support existing bailouts. Add in 2013 and that number almost doubles.

At the present time there isn’t much in the way of €800bn hanging off the world’s trees. The IMF’s entire gold reserves, for example, would cover payments until about the end of October – assuming that they could sell the full 2,800 tonnes at the current price. Couple this with the whole of the Fund’s emergency lending capacity – US$750bn – and you still wouldn’t quite make it to the end of next year, even assuming they would be able to raise all this from their member countries (including the $178bn supposed to be provided by various members of the European Union).

Alternatively, there are a couple of countries that have foreign currency reserve assets big enough to cover the amount – literally a couple: China and Japan. Even if the Chinese were willing to help it’s likely that they would insist on unwelcome lending criteria (they have previously insisted on more competitive trading terms with Europe and security over infrastructure, for example). And in Japan the cash isn’t really spare. They have their own debt problems, having run budget deficits every year since 1992 – in fact, a bill approved this week will see the nation’s sales tax double to 10% in an effort to contain the problem.

Which brings us from the PIGS to the elephant in the room: sovereign debt problems are not confined to Europe. In Britain our banks have about US$300bn of exposure to France – over 12% of UK GDP. We could well become another domino to fall. And as the city of Stockton, California’s decision to file for bankruptcy protection this week reminded us (the tenth municipal bankruptcy in the last four years), the US is not immune either.

So, while it must be possible that the PIGS might fly – anything is possible – it is not desirable, no matter what some say. Not least because, when it comes to sovereign debt, there are plenty of pigs beyond the Mediterranean.

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29/06/2012 at 4:03 pm

Transmission Error

It has been quite a week for followers of central banks. On Wednesday we learned that there had been a nail-biting stand-off at the Bank of England that saw plans for more quantitative easing seen off this month by only five votes to four. A day later, the Americans added to the excitement with the Federal Reserve deciding to boost “Operation Twist” by (a strangely precise-sounding) $267bn. And earlier in the month, of course, we saw good old-fashioned interest rate cuts in Australia and China – and the strongest expectations of an ECB cut since eurozone rates last fell in December.

In some cases this can begin to look like panic. The US has enjoyed near-zero interest rates since the end of 2008; the UK since early 2009. Only in present times could a policy rate of 1% in Europe start to look a bit on the high side. If rate cuts aren’t working, and more innovative monetary mechanisms are disappointing too, then – what can be done? Are we all doomed after all?

Indeed, the evidence that policy is not working has been mounting of late in the eyes of some. Growth in the US labour market seems to have stalled again. The UK has re-entered recession. China’s engines have slowed, some developed and emerging economies are fearful of commodity weakness and of course there is Europe, forever threatening catastrophe and weighing on everybody’s confidence.

All this gives credence to one of the strongest bear arguments of all: that monetary policy is broken. Central banks are powerless to encourage recovery, and all the action this month is just so much “pushing on a string”.

And yet there are plenty of people who complain that low interest rates are having a real economic effect. Cash savers in the US, for example, have long expressed dissatisfaction with Fed policy, and private pensioners and annuitants have similarly suffered from low long term rates here in the UK. Now: from governments to businesses to mortgages to student debt to credit cards, the volume of borrowing in these economies is orders of magnitude bigger than the volume of saving. According to the textbook, therefore, while savers suffer, this should be outweighed by the benefit to borrowers. So where’s the recovery? What’s going wrong?

The answer, to some extent, is that there is trouble with the transmission mechanisms of monetary policy – the systems through which central bank activity feeds through to the economy. Most obviously this means the banking system. While the Bank of England was very successful in lowering mortgage rates, for example, a number of headwinds meant that lending banks were significantly less keen – or less able – to advance mortgages in the first place. The credit crunch demolished the marketplace for mortgage debt; it placed a huge strain on balance sheets; the government increased taxes on banks and bank staff; and regulation has reinforced the near-abolition of self-certified, low deposit and interest-only loans.

In Europe there is a similar tale, with governments desperate to see bank lending improve on the one hand while imposing ever higher capital requirements on the industry on the other (and that not exactly in the nick of time). In the US, the existence of Operation Twist itself reflects the disconnect between short term central bank lending rates and the long term yields to which the country’s fixed-rate mortgage market is mostly connected.

Nonetheless, the monetary machinery is not completely stuck – not at all. American mortgage rates did take some time to come down: the average mortgage, which cost a little over 6% in 2008, had fallen only to 5% a year after the Fed cut to zero, and it wasn’t until this year that they reached their 3.9% low. Still, no matter how long it has taken, that lower rate has meant the prospect of more money in the pockets of US homeowners, and it has helped the battered real estate market continue its slow-paced recovery too.

Similarly, while new mortgage approvals remain at low levels this side of the Atlantic, the cost of existing loans plummeted when the Bank cut rates all those years ago. Again, that’s extra money in homeowners’ pockets.

Rather than pushing on a string, then, central bankers are making a net positive contribution to growth which faces headwinds from elsewhere: in some places inflation, in others unemployment, in others the necessity of reducing the national debt, and almost everywhere the sheer nervousness abounding in the wake of the most severe economic crisis for at least a generation.

The obstacles are not trivial, but neither is the cost of money. It may not be time to jettison the textbook just yet.

22/06/2012 at 3:20 pm 1 comment

Dying Breed

Last month we looked at the various refuges available to investors in the event of market panic. One of our conclusions was that:

The most effective hedge against panic is government bonds (though only those seen as safe).

Since then, both the broad statement and the caveat would appear to have been proved. From the US through Europe to Japan, developed market equity indices lost between 6% and 10% of their value (in local currency terms) during May. Gold and silver suffered by similar amounts. And government bond yields in several countries reached record lows, with ten year issues in Europe and the US posting gains of 3.5-4.5%.

As for the caveat: well, the price of the ten year Spanish benchmark fell by over 5% last month. Spain is certainly not a country seen as “safe” at the moment – as yesterday’s downgrade by ratings company Fitch underlined.

In fact, since we last looked at government bond ratings around the world, those rated “AAA” (as near as it’s possible to get to risk free) have become even more of a dying breed. The eurozone, of course, saw France and Austria fall to AA+ at S&P back in January. Finland, Germany, Luxembourg and the Netherlands are the only AAA rated euro countries left – and even they were subject to “negative watch” until a few months ago.

Outside the zone, the AAA club includes Switzerland, the Scandinavian countries and the UK – though even here there is uncertainty. S&P downgraded the Isle of Man to AA+ last November, and of course Fitch reminded us all yesterday that (along with Moody’s) they see the mainland’s AAA rating as being at risk over the next year or two as well.

There has been less drama in other developed countries. Japan suffered a couple of downgrades, but in any event has not been a AAA debtor for many years. The same goes for New Zealand. Outside Europe – following last summer’s US downgrade, again courtesy of S&P – the only other members of the AAA club remain Canada, Australia, and Singapore.

And yet there is a limit to the importance of all this. If bond markets close to an economy with deficit funding or debt refinancing needs, that is a serious development with potentially grim consequences. But if credit ratings fall, bond yields remain affordable and markets stay open, it’s a different story.

So it is interesting that ten year US and UK government bonds yield less than Dutch ones, even though their ratings and / or outlooks are “officially” worse. And Japan’s low bond yields are notorious despite the slow deterioration in its credit ratings over the years. At the other end of the scale, Spanish bonds have sold off today – but not by much (the ten year bond yield is currently 6.19%, 0.15% higher than yesterday’s close). And in Ireland, which is still rated junk by Moody’s, the same five year bonds that reached yields of over 17% a few months ago have spent most of 2012 below 6%.

Of course it is hardly necessary in these nervous times to remark that ratings companies may simply be getting ahead of the game. Perhaps Spain will follow Portugal into bailout country, despite the protestations of its government to the contrary, its relatively low debt burden and the yet more unpalatable fiscal trajectory that it might subsequently face. But bond market reactions to some of the higher profile sovereign downgrades we have seen in recent months suggest that they might have lost some of their power – to surprise, or influence, or both.

After all, take a step back and there is something rather funny about seeing Fitch downgrade Spain because it has to stand behind its banking system. A few short years ago, the ratings industry was citing likely sovereign support as a reason for being positive on rating bank debt through the cycle (banks being, by coincidence, among the keenest issuers of debt and the ratings companies’ biggest clients). Moody’s notoriously upgraded the big Icelandic banks – Glitnir, Landsbanki and Kaupthing – from single A to Iceland’s then sovereign rating of AAA in February of 2007, just as the first signs of the subprime crisis were becoming visible over the Atlantic, on this very logic. Within two years they had all got their sovereign support – and defaulted anyway.

The desirability of owning paper issued by a dwindling band of “safe” governments is understandable in a crisis. In recent times, however, investors have clearly looked beyond credit ratings in betting where safety really lies. Perhaps the ratings companies’ agitated caution will prove more insightful than their pre-crisis complacency. What is certain is that AAA-rated sovereign borrowers aren’t the only ones who don’t like the idea of numbering a dying breed.

08/06/2012 at 4:06 pm


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