IS THERE SUCH A THING AS A “SAFE HAVEN” BOND MARKET IN EUROPE?
One of the more interesting developments in Europe over the years has been the extreme divergence in the bonds across the region. Germany has typically been referred to as the “safe haven” with France running a close second. This is simple to justify. These economies remain the largest and strongest in the region. They’re also in the driver’s seat when it comes to this whole crisis so the odds of one of these nations defaulting is extraordinarily low.
But an interesting divergence has occurred in the last few weeks. French bonds are starting to drift away from Germany’s bonds. This can best be seen in the following two charts which show the developments over the last few weeks. Figure 2 also contains the bonds of two notable currency issuers – the USA and UK. As you can see, Germany’s bond yields have moved down in lockstep with those of the currency issuers.
Obviously, sovereignty matters a great deal in the Euro crisis. After all, the lack of sovereignty is the reason why these countries can “run out” money in the first place. But why does Germany fit into this neat little box if they’re not sovereign in the Euro? And does the deteriorating situation in France make it clear that Germany is also at risk? Personally, I don’t think any European bond markets can be fully trusted. Without sovereignty, there is no such thing as a risk free bond in the region. This doesn’t mean I believe France and Germany will default. In fact, I think that’s out of the question. The markets are voting with their money on the nation that they perceive as the strongest of the lot within the EMU. But the lack of sovereignty issue makes them all vulnerable to sudden spikes in yields at the whim of a sentiment change in Europe.
So, not to belabor the point, but I feel that 10 year German Bunds are an absolutely atrocious deal at 1.78%. This doesn’t mean the risk of default is on the table, but the simple fact that default is a risk at all makes these bonds infinitely more risky than, for instance, a US 10 year note at 2.05%. In sum, the term “safe haven” in Europe appears to be a bit of a misnomer in my opinion. Nothing is safe as long as this wretched monetary system continues to exist in its current format.
German/French bond spread
French yields are clearly diverging. That is frightening. If it continues theres no doubt the Euro banks are donezo. 2 Months before ECB goes nuclear or Italy’s insolvent. All EMU sovereigns are going to end up with free money from the ECB except Germany. Can’t last long. Only question is how severe will the crisis have to get for the EU to act appropriately/adequately or will the markets force them apart first?
It’s anyones guess. Social unrest ferments and unfortunately I suspect we’ve not seen anything yet.
Cullen i think you ‘d also find a french bond price chart interesting. French bonds were basically trading over 100 for quite some time and they ‘ve dropped under 100 during the last few days. That’s the real danger zone. Even if a bank holds them to maturity it limits the availability of funds since ECB will haircut them when posted as collateral and money markets will place a larger premium on the rate asked in exchange for liquidity.
So where to from here? Is it the end of the euro-zone soon?
http://pragcap.com/whoa-thats-a-lot-of-private-sector-savings-i-mean-debt
Cullen – with regards to this article, would it be true to say that the total level of private sector savings in an economy must be the total accumulated budget deficits since the start of time?
dont forget the effect of a trade deficit
German bonds are the benchmark, at least as long as there is no alternative (e.g. ‘eurobonds’). But the movement in French yields is indeed very alarming. So much for the “AAA” rating, huh. The only true AAA bonds are those backed by a central bank (US, UK, Japan, etc), and a small number of low-leverage companies (Microsoft, Apple, Google, etc).
Perhaps the markets are pricing the fact that Germany is the only EMU country that could if it chose so reintroduce its own currency and then watch it rise in foreign exchange markets.
If Germany were to get back to the DM say next week on a one to one exchange rate to the euro there is no doubt the new DM would massively rise in value versus the euro. Holders of German bonds would be better off.
Germany has a safe unilateral exit option from the euro mess. Other countries haven’t got this option. In that sense German bonds are truly risk free.
BINGO! You nailed it. The only thing i wonder though if this speculation is really realistic. I mean the DM / Euro ratio is no secret, the DM is about 50 % of the euro value. Sure it wouldnt stay there once on free float but could it double ? Even at its best times the DM was never worth more than the USD. So a USD Parity would already be allot, but stronger than Euro now ? Doesn’t seem realistic but i guess thats what the Bond Markets are thinking.
Thanks…
I also think that the initial parity of the new(putative)DM versus the euro would be irrelevant, for it’s simply an accounting convention decision.
Germany’s GDP is now about 2.5 trillion euros. If the Germans decide on an initial parity of one-to-one versus the euro then Germany will start with a 2.5 trillion DM economy under the new currency. If instead they decide on 2 DM for one euro (half an euro per DM) then the GDP will be 5 trillion DM in nominal terms. But of course the underlying reality has not changed at all. The real economy is still the same, it’s only the scale of the measuring rod that’s been changed.
What counts is what happens at moment zero plus one second, when the new DM would start trading on the foreign exchange markets. The market operators would be eager to buy DMs and sell euros, sending the new DM exchange rate north. It would certainly appreciate versus the rump euro – let’s say, by 30%. So, it would either go from 1 to 1.3 euros or from 2 to 2.6 euros depending on the moment zero (arbitrary) exchange rate.
Of course, this appreciation would help correct the chronic current account imbalances within Europe, themselves a result of Germany’s chronic surpluses.Germany’s exports would become 30% dearer in euro terms and her imports 26% cheaper in DM terms.
In sum:precisely the type of correction in relative prices that Europe needs in order to engage the process of solving its crisis…
oops..I meant to say the DM would go from 0.5 euro to 0.665 euro. Sorry about the mistake.
I think the question should be “Is there such a thing as a safe haven bond market anywhere”. Once the French bond market begins to deteriorate it would not be unreasonable to expect that German bonds would come under pressure due to Increased responsibility to save the rest of Europe. The pressure on the ECB if that happens would be magnified and I would not be surprised if some form of unsterilized QE ensues by the ECB. Many will say that this is exactly what is required to save Europe, but I think there will be consequences. The Euro will drift lower and without intervention the UK might see a trade drop as a result. China, who really pegs against both the Euro and Dollar, may well slowly devalue to maintain trade with Europe. The UK and US are then in a position where trade is dropping of, GDP is shrinking and deficits are not declining. The only option for the UK and US would then be to perform unsterilized QE or their bond markets will come under strain.
There is a problem with unsterilized or even sterilized QE in my view that it is usually targeted in a way that would produce an asset bubble elsewhere, typically in equities or commodities. You end up saving the safe haven bond market but at the expense of stagnant wages and consumer price inflation. GDP does not rise and very soon you are back to where you started. Where I expect QE to be targeted is at sovereign debt, since an easing or reduction here would help bond markets. The problem is that if you change debt dynamics you place investors in a position where they either need to move their money elsewhere or they need to re-invest somewhere else (You create a bubble in another asset class or drive safe haven flows).
I perceive though that there is a way for it to work, but it requires further actions on a global scale. You could for example default on 20 percent of all sovereign debt and then perform QE to pay off a further 20 percent. Money supply increase then matches capital destruction. It needs to be done globally to prevent currency fluctuations. This way you save the bond markets, without asset bubbles and inflation.
Even this though is just kicking the can down the road if you don’t start to produce growth. Now I know MMT theorists suggest they have a solution to that, but there are some other options which should be considered which address some of the fundamental inequalities which have led us to this point. I would target 3 areas, namely corporate responsibility, corporate taxation reform, corporate standards. For corporate responsibility I would suggest OWS certificates for firms which can show top management wages reflect employee numbers and the lowest wage paid by the firm , show a commitment to training young new employees and show a commitment to providing properly for employees once their work life is over. On taxation I see no point taxing a firm which is making no money, so I would propose a variable corporate taxation rate depending on the size of profits relative to turnover and number of employees, with discounts for investments in local communities and utilized apprenticeship schemes. The last objective for me would be to re target Sarbanes Oxley to meet its objectives without the fragmentation of responsibilities it has caused. The objective should not have been segregation of duties (so you never have a single point of contact with a firm and things run like a auto production line, or Chinese whispers), but segregation of approval and checking duties (so you can have a single point of contact with many duties which would be subject to approval by different approvers). This way you would reward responsible firms, raise low level wages, de-shackle firms and employees and don’t kick firms when they are struggling.
Oh dear I have rambled off subject again, but I think solutions now have to be at a G20 level and no bond market is safe.
Brick,
I always enjoy reading your well thought comments. Very good points indeed.
Well done and well written! Keep up with the rambling!
Best,
Martin
While reading your comments in debt i thought to little late…i stil think the debt .forgiveness is not enough. Then I read further and agree we need a multi front attack against this debt deflaion. I would only add a the enactment of a law abolishes lobying in every country that participates in the plan and anyone caught llobying is charged with treason.
!
Yes perhaps I should have mentioned lobbying as it tends to morph every good idea into a business friendly and individual unfriendly idea. You probably need to go further and ban all business contributions to politicians with campaign funding coming from a central pot and fair allocations of media time. Thats the way most politics works around the world. The argument you will get with banning lobbying is that legislation may be badly designed or have unforseen side effects due to legislators not knowing enough detail. I prefer business input to legislation coming in the form of legislation being put out to review and comment by interested parties (including representatives for individuals). Legislators then gain new knowledge to better legislate but don’t then have the indebtedness to business. Lobbying is just too big a business to go quietly though in my view.
Spot on comment, but I think you must go further even, further than (most) economists go: we can’t grow.
Yes, that time has come, it had to come someday for a load of reasons (demographics, physical constraints or just mathematical impossibility). A lot of nations are not going to grow fast enough (not in nominal terms, much less in real terms). So eventually out of this never ending crisis we have to come with a reformed (or new) system which can function without growth (and I’m not even mentioning degrowth, where we are really heading).
Japan could kick the can for years because it was importing growth from the rest of the world, but now it’s just not possible. And I don’t think MMT has all the answers, but I could help a bit with it.
its interesting to me, that even if germany had a budget surplus, they’d still be at risk from a derelict ECB and a panicing bond market come time to roll debt.
nevertheless, I believe the markets are saner than that. and the only way the yields on german euro-denominated bonds would get out of hand is if people thought that germany was leaving for a new currency. (with the yield reflecting not German credit fears, but euro devaluation fears).
To see what will happen to individual country’s yields within the eurozone, look at the current acct balance. The deeply negative countries, Italy/Spain/France will all be in the same boat.
French long-term bonds seem like an easy short.
its funny how the euro value is holding up. i think it is because there is a liquidity crisis, and the euro banks need all the fucking euros they can get their hands on, rapidly depleting dollars, by exchanging them for euros. this almost matches the desire of foreign investors to dump euro assets.
I’m watching the US/Germany 10yr yield spread very closely. It has moved from -10 to +24 basis points over the past few months, which is the opposite of what one would expect based on default risk alone. However, inflation risk is the other major variable. The bond market appears to be saying that inflation risk is lower in Germany than in the US. Not surprising given the fiscal austerity/recession expected in Europe.
German Bunds are so low because of a simple fact – there are no alternatives for Euro users who want to get their principal back.(The sole exception is companies like Siemens who have a banking license and can stash their Euros with the ECB) If no bonds are risk-free, all the risk-averse money will pile into the least risky of the bunch.
“So, not to belabor the point, but I feel that 10 year German Bunds are an absolutely atrocious deal at 1.78%”
At this point, good quality European corporate bonds are probably safer than any so-called “sovereign” bond in Europe, including Germany.
Probably right. I don’t deal in European corporates, but I am sure there are some out there offering far superior risk/return…..
At least with corporate bonds, politicians can’t arbitrarily come in and shaft you for 50% like the they did in Greece.
Safe haven? In the same time the Ger-PIIGs spread has exploded the Euro was down up to -10% vs. USD. From a US investor’s point of view, I wouldn’t consider it a safe haven.
The market is saying the German’s are in control and will punish the PIIGS before they put their credit rating on the line. Forex markets are saying good luck with that.
Factoid heard on NPR’s Diane Rehm: at the G-20 conference, Sarkosy spent upwards of $30,000 on the French accommodations; the Chinese delegation, about $19,000 on theirs.
The Brits: about $1,100. That’s the kind of austerity I can believe in.
Source: BBC’s Kim Gaddis
O yes, Germany will default. No question about that. But only after both France and Italy have gone down. The predominant problem is that(, like in the US ???), government/state workers’ pensions and the german equivalent of Social Security are paid out of current taxrevenues. And that same system is also used in France, Italy, Spain, Belgium, Luxemburg.
It will be interesting to see in which sequence the dominoes will go down.
It’s quite logical: France has a Current Account Deficit and Germany has Current Account Surplus. Pull up charts from different EMU countries and see who has low/falling rates and who has high/rising rates. And combine that with which countries have a C.A. Deficit/C.A. Surplus.
E.g. Netherlands (Current Account Surplus) has rates only slightly higher than Germany, the UK and the US.
What confounds me is that the UK with its Current Account Deficit has such low rates. Perhaps the UK is the next domino to go down ?
Imagine you are the holder of a 10 year government bond. What is the difference between facing a 50% hair cut as in the case of Greece and devaluation via debt monetization during a 10 year period, so that respective to oil, copper, wheat the purchasing power of this currency is reduced by 50%.
I have to add that I will buy absolutely no government bonds in the near future. A well diversified bond portfolio of sound and solid enterprises, whose products are needed by mankond, is IMHO much safer. Moreover I prefer stocks over bonds.
“What confounds me is that the UK with its Current Account Deficit has such low rates. Perhaps the UK is the next domino to go down ?”
Willy 2, you asked this question above. There is a simple reason that the UK has much lower bond rates than EU countries that have Current Account Deficits. If you pay attention to MMT, then you would realize that the reason is that the UK controls its own currency, and that UK’s central bank, in a pinch, can be a buyer of UK gilts. The fact that the UK controls its own currency enables it to have policies that enable some growth, albeit slow now, and enables it to not go completely overboard with budgetary austerity. There may be no completely safe haven gov’t bonds, but the US, UK, and Japan are safer havens than any EU country because they control their currencies. I would agree that investment grade corporate bonds are probably a better risk/reward than any of the above three right now, although I do hold a modest allocation in US Treasury bonds.
You can’t understand what’s going on in Europe if you think spreads reflect default risks. Nobody seriously believe Italy or France can default but many think they might not be in the same monetary zone than Germany in the future. Spreads are mainly an indication of FX risks and potential devaluations. That’s why wealthy italians are moving their money to Germany and pushing up the bunds while all euro banks are getting rid of italian bonds
Eurocrats silencing their critics. http://www.economist.com/node/21538142
This doesn’t mean the risk of default is on the table, but the simple fact that default is a risk at all makes these bonds infinitely more risky than, for instance, a US 10 year note at 2.05% Cullen Roche
Because the US Government has no need to borrow in the first place then any interest it pays is welfare to its debt holders.
“Because the US Government has no need to borrow in the first place then any interest it pays is welfare to its debt holders.”
Bear are you not contradicting your self? If the US Government has no need to borrow why are you calling them debt holders?
Welfare to its debt holders? 2% minus inflation and tax is welfare?
Call it what you want within the sovereign modern money issuing world but its not welfare. They are paying more and more to them self anyway since the FED is now the largest holder in the World and it returns 98% of it gains to the treasury.
Welfare to its debt holders? 2% minus inflation and tax is welfare? First
Yes, since the government has no need to pay ANYTHING.
When there is no market priced money for a long period there can no longer be any real recovery and financial instruments such as Sovereign Bonds are not valued the same way. They will be valued on the basis that the European Central Bank will be the lender of last resort or will simply replace them. Why stay in such a contaminated environment when there are 20 other countries last year that registered economic growth rates above 8 per cent.
The Eurocrats Goal was political and the result is failure. If any one expect them to Fix this you will learn that patience is not always a virtue.
When there is no market priced money … first
Market priced money does not require government borrowing. It only requires that genuine private money alternatives to fiat are available. Then fiat would have to compete honestly with other alternatives for private debts.
To take a contrarian view, I feel the German bond is priced too low. The euro remains in demand and its holders need a place to park their savings. In the worst case scenario, the bonds mature in Deutschemarks. In the best case scenario, the eurozone slides into depression and the ECB cuts rates and remains on hold. Bond markets tend to get things right…
It is a ridiculously low yield, the lowest in history ever for Germany, but German bunds are the safest liquid European asset out there at the moment. However, i think a better and safer though less liquid investment is German real estate. 1. It is cheap both on absolute level (house prices to household income ratio for example) and on relative level (against all other European countries as well as against all developed counties). 2. Homeownership ratio in Germany is one of the lowest in the world. 3. Germans prefer to keep their money in a savings account in the bank..and rent – if they get worried that something bad is about to happen in Europe, and being such good students of history, they surely will withdraw that money, look at where the price of gold is, check their monthly rent (it is small – most rents are regulated and thus have not changed in years – but, even if small they add up exactly over the years) and buy a house.
All Euro sovereign debt has default risk, similar to municipal bonds in the US. Credit quality and risk analysis matter. Therefore, no true safe haven bond exists in the Eurozone, or anywhere else for that matter. US Treasury debt has the political risk of a small delay in receiving 100% of principal at maturity (e.g., the debt ceiling fight), but keystroke money via the Fed will always be there to pay off at par eventually. Whether par has been adversely affected or gutted by inflation is a separate risk analysis. Risk comes in many flavors: default, duration, inflation, political, natural catastrophe etc. etc. It might be a good subject for an article by TPC, because risk and uncertainty will always be with us. Diversification is a form of insurance for investors.
A good question for bond market operators to ask would be: how would Germany honor her debts in euro denominated bonds in case she decides to unilaterally exit the euro and adopt a new DM?
Bondholders would prefer that Germany decide to redonominate all the old euro bonds promised payments into DMs at the initial exchange rate, because the DM will presumably rise against the euro once it starts trading on the forex markets.
However, if Germany does not take this step her creditors will suffer a real and painful loss for the nominal payments would be worth far less than before in terms of German goods and services.
In this sense, today’s creditors (holders of German bonds)run a risk of partial default – if Germany drops the euro, maybe they will end up receiving only depreciated euros of a rump (ex Germany) euro zone.
Forex and re-denomination risk. Tremendous insight. Thank you Jose.
Bund-Oat spread is widening, but if you just pause for a second and look at the absolute level of OATs (namely the 3.30% area), you’ll realize that they’re almost at a record low.
So yes, France bond market is underperforming German bond market, but at the moment the French government can fund itself at the cheapest nominal level EVER.
Not that bad..(yet?)
“EFSF had spent more than € 100m buying up its own bonds to help it achieve its funding target after the banks leading the deal were only able to find about €2.7bn of outside demand for the debt.” Nice.
Cullen,
Do you think that top-heavy derivatives trading, such as naked swaps, is a likely factor in a potential Euro meltdown as it was in the US?
http://www.bloomberg.com/news/2011-11-13/merkel-says-eu-must-forge-closer-union-to-convince-bondholders.html
Wind of change?
It’s not interesting that yields are diverging, they’re doing what they should be doing. What is interesting is that they converged in the first place and stayed pegged for so long.
This is the source of the euro crisis which is, at its heart, a current account crisis fueled by a kind of “credit Schengen”. Leigh Harkness explained the mechanism of this well. We are in crisis now because the rate of return to a natural state is unconstrained and hence very rapid following an extended period of rate pegging in which imbalances were able to build up far too much. The rate of change demands fiscal change that is too rapid and extreme for citizens to tolerate. What is therefore needed is unconstrained ECB OMO designed to take the heat off / reduce the rate of rebalancing to a more acceptable level. This is conceptually simple but politically difficult.
Standing in the way of this is Germany so the solution, as I and others have recommended, is to weight OMO decisions by current account, in other words, give nations such as Germany and the Netherlands the dominant voting power. Germany doesn’t really have any other choice here, it has to accept some inflation or be responsible for destroying the euro.
All the talk about Europe collapsing is Chicken-Little stuff and only becomes definite if Germany leaves the euro (and maybe EU) out of national pride. We still have a lot of territory to explore before things really start falling apart. Does Greece have to be booted from the euro? Absolutely, Greece should never have been allowed to join in the first place. Beyond that, granted expanded ECB powers under authority of surplus nations, the continued return of yields to a native state can be managed until the spread between current accounts in the eurozone is resolved. It will probably take two decades, but it can be done. Some fiscal convergence must naturally accompany this (although not so far as a full fiscal union).
In fact, the ECB has already been engaging in yield relief by stealth (as I pointed out some six months ago). I strongly recommend taking a couple of days to understand the following post from a British central banker: http://reservedplace.blogspot.com/2011/07/right-on-target.html