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Welcome to the Hotel California …

...you can never leave! Global bonds and currencies

We think the Hotel California analogy may have been used before but it is still highly relevant. Following a decade of government overspending and ‘Keynesian’ stimulus, European governments are faced with a large bill and have begun the process of fiscal austerity. As a result, zero interest rates and ‘quantitative easing’ (essentially the creation of new money by central banks for use in the economy) are likely to be a regular part of our lives for some time to come.

One of the features of the ‘all change’ world, in which we suffer the after-effects of the previous decade of borrowing, is the constant need to keep bailing out those borrowers who lose the support of the markets. The markets have switched their attention from the US banking system to the Eurozone government bond market, and they could switch it back to the US later this year.

Crises of confidence about the wellbeing of particular debt issuers have been played out many times in the ‘all change’ environment and, during the first week of May, such a crisis was taking place in the Eurozone.

If the rot can be stopped early enough, the downward cycle initiated by the difficulties of a particular issuer may be prevented; some say that if governments acted as fast, or faster, than the markets expected them too, government debt crises would not develop. The US banking crisis that occurred in the wake of the global credit ‘crunch’ was punctuated with bigger and bigger bailouts, each expected to ‘shock and awe’ the markets and break the downward spiral. Such a shock-and-awe approach has also been tried in the recent Greek/peripheral European debt crisis. Unfortunately, once the bond ‘vigilantes’ start to run scared of the markets, the sequence of events is hard to stop because of two factors: first, the rating agencies downgrade an issuer as market conditions deteriorate, thereby forcing some credit-quality-dependent investors to sell regardless of their views. Secondly, governments generally cannot move as fast as the markets expect them to owing to their need to build consensus.

Eventually, a point of no return is reached and drastic action is required. The action cannot be taken too early as it would be seen as counterproductive. What is required is an investor who does not have to ‘mark to market’ (value their asset at the prevailing market price) and who does not need to sell if the rating on the bond changes. That investor is the government itself, usually in the form of the central bank. Given that, in such circumstances, there is generally no spare money for the government to buy bonds, the funding for these purchases has to come from printing money or from diverting it from some other area.

The markets are likely in the period ahead to turn their attention to the next candidate for the focus of the bond vigilantes, which is likely to be the UK (swiftly followed by the US). In the UK, the existence of a new government could accelerate the process of deficit restructuring as there is a temptation in the early days of an administration to highlight all the negative news and blame it on the previous government. Then, with a fresh budget plan and low interest rates, the economy can recover.
In the early 1990s, the US was able to alter the markets’ expectations about the deficit by raising taxes and reducing spending growth to below the trend rate of GDP growth. This period of fiscal austerity was so remarkable that by the end of the 1990s, the markets were starting to panic about the ‘disappearance’ of the US Treasury yield curve.

At some point this year, and once UK and the Eurozone governments have put their plans in place, the markets are likely to focus on the lack of progress in the US, particularly in key states such as California. The difference between the US states and the Eurozone is that the former have balanced budget legislation which does not allow them to carry over increasing deficits year after year. The problem is that they have been struggling to make ends meet since 2008, but they have been supported by fiscal stimulus and federal funding. The main source of support has been funds coming from the American Recovery and Reinvestment Act, which was passed in February 2009. These monies will run out soon, which means that the states are now focused on cutting spending. Compounding the position is that many states have already used their contingency reserves and cut services to keep their budgets in balance. Cutting their spending to levels consistent with the new reduced levels of tax receipts in the absence of federal support is the major challenge they now face. There remains the possibility that some of the support may be extended, but this only delays the inevitable.

Just as in the Eurozone, US fiscal austerity measures are now being planned and will soon have to be implemented. As with the Eurozone, the US authorities will be slower to tackle their indebtedness than the market expects and, as a result, the bond vigilantes are likely to be concerned. These concerns will almost certainly not be as severe as those applied to Greece. The US is a much larger economy and, although the current US budget deficit is high (at 11.1% of GDP), it is manageable. Also the US economy appears to be more dynamic and to be on the road to recovery. Finally, the public-sector spending ‘creep’ that the Europeans had experienced was not as prevalent in the US during the period leading up to the financial crisis; as such, it is easier to forecast an improvement in the US budget deficit, should the economy recover.

Governments will resort to quantitative easing (QE) if investment in their bond markets is destabilised. QE, together with a prolonged period of low interest rates, is inflationary in the long run, but probably only once the ‘deleveraging’ (repayment of debt) period is over. In the meantime, liquidity flows shore up confidence in the government bond market rather than find their way into the real economy; and until the deleveraging process is complete, it is hard to cease these liquidity measures. As the words from the Eagles song suggest, once you have entered the Hotel California ‘You can checkout any time you like, but you can never leave!’

An environment of very low ‘short’ rates and fiscal austerity is usually good for bond markets. Eventually, loose monetary policies will have to be unwound but, for the time being, bond markets appear to be well supported.

BNY Mellon Asset Management – Viewpoint
Prepared for professional investors only – May 2010

Mercredi 9 Juin 2010

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