30th October 2013
Lombard Odier has just issued this opinion concerning the fate of world bond markets. It says it was responding to an opinion in the New York Times from Nobel Laureate Paul Krugman who slated those he said subscribe to fantasies of fiscal apocalypse.
The investment bank has not been able to resist giving its view which we report below.
The US is not Greece
On this front, we agree with Dr. Krugman that comparisons invoked by experts such as Alan Greenspan between the US and Greece are way off the mark. In lending/borrowing markets, the absolute size of debt matters. Using Keynes’ words, “if you owe your bank manager a thousand pounds, you are at his mercy. If you owe him a million pounds, he is at your mercy,” hammers home the point clearly.
With China, Japan and now the Federal Reserve holding the vast majority of US government-issued debt, it is easy to work out that none of these big creditors have a strong incentive to initiate a run on US government debt on the back of fiscal worries.
China and Japan still rely on the export model to generate growth in their economies and in this export-led system, the heavyweight demand (by a margin) comes from the US consumer. Hence, from the perspective of the Chinese and Japanese governments, taking a decision that increases the cost of funding for the US consumer has a strong side-effect in the form of a negative external demand shock for these countries, which we estimate will be enough to push them into a deep recession.
From the Federal Reserve’s perspective, the dual mandate—which includes the strong emphasis on employment— means that a sharp rise in interest rates will be considered a negative demand shock with negative implications for labor market dynamics. Indeed, the outgoing Chairman, Ben Bernanke, has already indicated that it is unlikely that the Federal Reserve would ever sell the treasuries sitting on its balance sheet and any exit from the QE program would be a very gradual one. Again, here it is easy to see that the central bank is unlikely to react to any deterioration in fiscal flows, given treasury holdings and current buying is a monetary policy tool, rather than an asset that generates income or capital gains or a store of value that is affected by underlying credit concerns.
Furthermore, the fact that the US issues debt in its own currency is a powerful backstop against shifting investor sentiment. Inflation as always is the key risk factor here, but as we have seen, the quantitative easing program is neither a necessary nor a sufficient condition for run-away inflation in a world of low money velocity.
Finally, it is important to note the difference between 2008 and any potential run on the US government debt market.
The story of 2008/9 was one of over-borrowing by the private sector, leading to a housing market collapse, which in turn exposed the linkages between the financial and real sectors of the economy. Under this scenario, bond yields fell as safe haven demand increased and growth and inflation expectations were revised down.
On the other hand, a market-induced de-leveraging of US government debt is a different matter as it would entail a sharp rise in bond yields irrespective of current and forward economic expectations and as we note above all the key players involved in this set-up have little incentive (especially with inflationary dynamics so benign) to initiate such as shock, given the huge negative externalities attached to such a decision.
In a more practical sense, turning to current monetary policy considerations, we continue to believe that we are likely to see several cycles in policy thinking and its implementation by the Federal Reserve, which is likely to use a trial error approach to policy calibration (the summer months were a good example of that). In such an environment, we strongly believe that a long-only fixed income benchmark approach appears ill-suited to deal with increased uncertainty.
How the US works is not a template for emerging markets
Given the size, liquidity and reserve currency advantages that the US enjoys, it is important to note that other countries (especially emerging markets) are exposed to more traditional economic forces, which most of us can intuitively understand. Fiscal deterioration and/or policy uncertainty is more likely to get punished (especially if accompanied by actual or perceived changes in liquidity) and, as we noted above, the size of the market relative to the creditor balance sheet matters. Put simply, the leeway available for the US is unlikely to be offered to other countries, if they decide to go down the same policy route.
Apocalypse cancelled (for now)…
The euro zone is an example of where the credibility of policy, politics and institutions can a play powerful role in investor’s assessment of the underlying debt markets. Greece is an important example, as we think that the major
driver of the spread (vs. bunds), which has appeared in the market since 2010, is a function of investors’ belief (rather than actual fundamentals) that Greece no longer enjoys an unlimited backstop from northern European countries, which was the accepted view before the crisis.
The German policy of circumventing moral hazard via austerity punishment is a manifestation of this questionable backstop and the primary reason behind the dispersion between periphery and northern countries debt spreads we see today. A dynamic which we believe is likely to remain in place. Investor mood swings towards both periphery bonds and the single currency on the back of policy changes (actual and promised) are likely to continue, but we only have to read the Bundesbank assessment of the situation to conclude that issues in the euro zone remain far from fully resolved.
All told, apocalypse in the euro area seems to have been cancelled for now, but with debt burdens rising (indeed in Greece’s case the public-debt-to-GDP ratio is now almost back to pre–private sector involvement levels) and the German policy of muddling through in full force, it is too early to declare mission accomplished. The improvements we see right now are more driven by the increased home bias of domestic banks (which have been using LTRO money to buy domestic debt) and the accompanying change in investor sentiment.
To conclude, we think it is worth paying attention to arguments made by both Paul Krugman and the so called “fiscal scare-mongers”, despite the obvious inconsistencies.