Saturday, January 26, 2013

2013 Outlook Part 9: Chapter 2 Of The Sovereign Debt Crisis Begins


After spending a few sections of this outlook looking at the United States and the impact of low interest rates on markets within that country, it is time to now to take the conversation global.

In 2012 there was a critical change in the landscape of the sovereign debt crisis. This important change closed the door of chapter 1 of this crisis and simultaneously opened the door to chapter 2. It was the announcement from the European Central Bank that they would provide "unlimited" money to stand behind sovereign debt. Up until that announcement it was uncertain where the ECB stood and if they were ready to do "whatever it took" to stop rates from rising. By this I mean they were ready to print an unlimited amount of money to push the debt bubble down the road.

Psychology plays an extremely important role in the bond market. This has also been know as "trust" or "faith" in the debt one is purchasing. Up until this point in the sovereign debt crisis, investors have wanted to know that the nominal value of the bonds they purchased would be returned after the term of the bond.

This is why Europe was ground zero for the origins of the crisis. It was obvious to anyone who could handle simple arithmetic that the governments in Europe had no possible way of paying back their debts. What was unknown was whether the ECB would stand behind the bankrupt governments 100% with their printing press. Bond buyers do not like uncertainty. Especially those that are buying government bonds. 

Many of the more experienced investors still remember being on the wrong side of Russian debt in the late 1990's when they defaulted. That event by itself was almost enough to cause a Lehman like chain reaction in the financial system, at a time when the market was just a fraction of the size it is today.

Fast forward to the beginning of 2010 and investors begin to smell trouble around the government bond market in tiny Greece. Greece has been so important over the last 3 years, not because of the risk of their debt to the financial system, but because how that country was handled would create the blue print for the rest of the larger bankrupt countries throughout Europe.

The ultimate resolution was a carefully crafted write down of a significant portion of their debt (investors were forced to take losses), leading to complete chaos throughout the rest of Europe. If Greece debt was written down, then investors believed it could happen in Spain or Italy. Uncertainty leads to fear and fear leads to pressing the sell button. Bond yields began to blow out across both Spain and Italy, and it was rapidly moving to the point of no return; a Greek like moment for these two nations.

This was why the ECB finally threw in the towel and agreed to stand behind all the toxic debt in the system. I have been writing about this moment for years. My ultimate belief was that the central bank would cave and money printing would be the ultimate resolution. I have often discussed not only this event occurring by how that would impact the markets moving forward.

Why is it so important?

The major developed nations around the world, which make up a significant portion of the global economy, also have governments with toxic balance sheets that look just like Greece - only with many more zero's. The key difference, and why you have not heard a peep from them so far during this crisis, is that their central banks began this process with the market understanding that their central banks would do anything to protect their debt markets, aka, unlimited money printing. 

While in years past this was only assumed, it has recently been confirmed from the central banks themselves. In just the past few months the Federal Reserve has announced QE-ternity. They will purchase $85 billion worth of debt every month until the unemployment rate reaches 6.5%. The Bank of Japan has recently announced a similar program of unlimited QE until their inflation rate reaches 2%. The Bank of England has followed suit and agreed to print money until the economy recovers, an economy that has just recently slipped back into recession.

All these countries plan to boost growth through a lower currency which will help their export markets. The problem is that these currencies are valued against each other, which has created a modern day currency war. I will come back to this very important point in a later section of this outlook.

The second reason they have embarked on this process of currency devaluation (the part that is never discussed publicly) is that the central banks are actually GDP targeting. GDP is a number that grows in a nominal fashion - it is not inflation adjusted. Central banks are well aware of this very important fact.

Therefore, if they increase the price of goods, stocks, real estate, etc. across the board, the nominal value of GDP in that country will increase in size. During this nominal boost to GDP, the value of debt simultaneously falls (bonds do not track the rate of inflation which is why they are lethal during inflationary periods). 

If the nominal GDP rises by 20% over 5 years and the debt within the country only rises by 10%, they have still lowered the total debt to GDP rate over that period. This process is known as financial repression. For a more in depth and easy to understand discussion on this topic see: What Is Financial Repression?

Financial repression eases the burden of debt repayments by making that debt less valuable. The key to this process is to do it very quietly. You can think of it like boiling a frog. For 99% of the process the frog does not even realize that the water is getting warmer because it is happening slowly. This is exactly what is taking place in the bond markets today. Investors are putting their money into a fund that yields 1.5%, while the central banks have told them (those that are listening) that it is now their mandate to achieve 2% inflation. That means it is the central banks goal to make those investors lose .5% a year in purchasing power.

This had led us to the crucial point we are at today when the second chapter begins. We are in a transition phase from the point where investors are terrified of losing their investment principle (European government bonds) to where they will ultimately be worried about the value of that principle when it is returned (all government bonds).

The important question now is, what bond market will be the first to experience the impact of this new psychological shift? 

Enter Japan. Ground zero for the second chapter of the sovereign debt crisis.



1 comment:

  1. Excellent work. This is the clearest, most concise summary of this issue that I have come across.

    Thank you.

    ReplyDelete